Nearly five years after entering a kind of monetary wilderness, there remains no obvious way out for the Federal Reserve. Indeed, at times, the Fed seems to be stumbling deeper into the jungle, getting itself more deeply entangled in unconventional policy experiments.
The Fed has held the Federal Funds rate near zero for 3 1/2 years, signaled it expects to keep it there at least through late 2014 and bought more than $2 trillion of bonds in two rounds of quantitative easing (QE) to push long-term rates to record lows.
Yet the economy is growing too slowly to generate the kind of job growth needed to persistently reduce unemployment.
Most recently, the Fed's policymaking Federal Open Market Committee felt the need to prolong its "maturity extension program," better known as Operation Twist, in the face of slowing growth, weakening labor markets and what it calls "significant downside risks" from Europe. It will buy another $287 billion in bonds by the end of the year, financed by sales of shorter-term securities.
It's hard to miss a note of frustration, perplexity and dissension among Fed policymakers as they survey the economic and financial landscape in this age of transparent Fed communication.
Some, such as Chicago Federal Reserve Bank President Charles Evans, suspect the U.S. is precariously close to being in a Japan-style "liquidity trap," a black hole of monetary policy from which escape is difficult, if not impossible. Indeed it was to avoid that dreaded trap, in which interest rates can't fall low enough to revive economic growth sufficient to reduce unemployment, that the Fed has aggressively used unconventional credit easing tools.
Evans' answer is to buy mortgage backed securities and other assets even more aggressively and to pledge to keep the funds rate "exceptionally low" even longer.
Others, notably Dallas Fed President Richard Fisher, question whether the Fed can do anything else constructive. The Fed already has slashed rates near zero and more than tripled the size of its balance sheet, they argue. Now, it's up to fiscal and regulatory authorities to do their part to boost growth.
End the uncertainty about taxes and regulations and lighten the governmental load on the private sector and it will respond, some argue.
It generally is agreed that monetary policy is less effective than normal because the credit channels are clogged because of tighter mortgage standards and regulatory disincentives to lend. But there is less agreement on what to do about it.
San Francisco Fed President John Williams asserts, "If the channels are clogged, we need to do more." But St. Louis Fed President James Bullard warns, "If you try to push so hard on monetary policy even when the mechanism isn't really working, the whole thing blows up on you and you get a lot of other problems."
Well, the Fed is not likely to stop pushing, even if it is "pushing on a string," as Fisher alleges. The predominant view is that, whatever the obstacles might be, the Fed is duty bound to do everything possible to try to fulfill its statutory dual mandate of maximum employment and price stability. In the current disinflationary context, "price stability" means keeping the inflation rate from falling much below its 2% target.
So, even though its past monetary exertions have had only sporadic success at best, and even though there are a number of non-monetary impediments to more robust economic growth, the Fed stands ready to do even more.
It should have come as no surprise that Fed Chairman Ben Bernanke defended the extension of Operation Twist as a "substantive step," but then declared, "We are prepared to take further steps if necessary to promote sustainable growth and recovery in the labor market .... If we're not seeing sustained improvement in the labor market, it would require additional action."
Bernanke told reporters he "wouldn't accept the proposition that the Fed has no more ammunition. Our tools, while nonstandard, can still create more accommodative financial conditions (and) can still help us return to a more normal economic situation..."
So don't be shocked if we see an official "QE3" at some point if the economy continues to struggle.
If the kind of economic conditions that prevailed leading up to the mid-year meeting — slowing growth, 8.2% unemployment, falling inflation and the threat of negative spillovers from Europe — continue to prevail, a third round of large-scale asset purchases seems all but certain. The way forward is anything but clear. The exact contours of future monetary policy are as uncertain as the times.
The FOMC will have to weigh the benefits of further quantitative easing against the costs, which include making it harder for the Fed to eventually execute an exit strategy, potentially impairing market functioning and the risk of stirring up inflation expectations. But it seems safe to say that, so long as the expansion remains subpar and resource utilization rates low, and so long as major downside risks from abroad loom, the Fed will keep an easing bias — a quantitative easing bias.
Fed officials would love to return to more standard ways of conducting monetary policy. Alas, exit from the seemingly unending morass of bloated bank reserves, zero rates and crisis management looks as distant as ever. The number of FOMC participants predicting that rate hikes will be delayed until 2015 grew in June from four to six.
Shrinkage of the Fed balance sheet is probably even further off — unless by some stroke of luck (or, some would say, an election result) the U.S. economy is released from the gloomy spell it's been under and it recovers its historic dynamism.