The FOMC’s Options

When I was on the FOMC (1991-2004), I arrived at the meetings with “soft conclusions” formed. By that I meant I went in with my preferences, but with a mind open enough to be persuaded otherwise. Tonight, my conclusions are softer than usual, but here is the context of tomorrow’s FOMC decision as I see it.

The State of the Economy

The economy, never strong, has weakened further. The last two headline real GDP numbers, while weak, nevertheless overstated strength. The headline numbers were 3.0 percent in the 4th quarter and 1.9 percent in the 1st quarter. Stripping out inventory accumulation, however, leaves real final sales at 1.1 percent and 1.7 percent respectively, and less than 1 ½ percent growth over six months.

We have two consecutive declines in monthly retail sales; monthly jobless claims are drifting back up; industrial production declined in May; and the University of Michigan’s consumer sentiment index dropped substantially in May.

While welcome, the recent further decline in inflation reflects weakness. The PPI declined 1 percent in May after a decline of 0.2 percent in April, and no change in March. The CPI declined 0.3 percent in May after no change in April.

Clearly, whatever the case for additional ease by the Federal Reserve, it has increased recently. In terms of the dual mandate, employment/unemployment has worsened while inflation has improved.

What about QE3 or continuation of operation twist?

Operation Twist—the sale of short-term securities and purchase of longer-term maturities to put downward pressure on longer-term interest rates—expires at the end of the month. To end it would probably put some upward pressure on longer term rates and would be taken as a tightening of policy. To continue it may be less of a disappointment to markets, but it is unclear that it would do much new good.

One problem with operation twist is that the security purchases and sales offset each other with no net impact on Fed assets and total bank reserves. The FOMC has said it would replace maturing securities alongside operation twist, but there has really been no net increase in its total assets in recent months. If additional stimulus is needed, Fed purchases should not be sterilized, or at least not fully sterilized. We need some new growth in Fed assets, bank reserves, and the money supply. Under the circumstances, such growth is unlikely to be inflationary. The growth in money that we’ve had has been offset by a decline in velocity.

Many say past growth in these variables did no good; so why have more growth. That ignores the counterfactual: what would have happened if the past growth hadn’t occurred? I believe that, as in the Great Depression, banks would have tried to satisfy their outsized appetite for excess reserves by shrinking other assets, including loans and investments.

What about reducing interest payments on bank reserves?

One way to encourage banks to utilize their excess reserves by increasing loans and investments and, thereby, pumping up growth in the money supply would be to reduce the 25 basis points the Fed now pays on reserves. I’d hate to see that happen because it took so long for the Fed to get authority to pay interest on reserves, which is an issue of fairness to banks. However, at the margin, given the low level of other short-term interest rates, that should make a small positive difference. Nevertheless, I’d be inclined to vote against this option.

What about doing nothing?

This option has some appeal since “the training wheels have to come off sometime.” While I would hate to see this option result in shrinkage of bank reserves and money, some slight upward pressure on interest rates I would welcome. These artificially low rates are distorting the markets, and it’s time to relieve the pressure on savers. However, I’d hate to see the negative market reaction to such a bold announcement. Someone said recently, and I don’t remember who, that rising stock prices are the only form of stimulus that doesn’t involve debt. Maybe the FOMC should purchase a broad index of domestic equities.

What about promising low interest rates beyond 2014?

This is a terrible idea, in my opinion. Of course, I thought the two earlier promises, the latest through 2014 were mistakes as well. They do work to help hold down long term rates now, as long as the Fed is credible, but I don’t think the lost of flexibility, and possibly credibility, is worth it.

So, where do I come out?

I could probably be persuaded to go along with the do-nothing option. However, going into the meeting tomorrow morning, I would be inclined to support a statement along the following lines:

“While we are not proposing another formal program known popularly as QE3, or even a formal continuation of the maturity extension program, known popularly as operation twist, we do expect to resume normal open market operations with a view to preventing a contraction in total Federal Reserve assets and promoting modest growth in bank reserves and the money supply. To the extent that this requires purchases of securities, we will probably choose the longer-dated maturities and will opportunistically purchase guaranteed mortgage backed securities. We do not view this as a major campaign, but as a return to normal discretionary open market operations.”


Comments (6)

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  1. BigEd says:

    Re: The Fed reducing interest paid on excess bank reserves: ” . . . . I’d hate to see that happen because it took so long for the Fed to get authority to pay interest on reserves”

    If the hard-won authority is so important, The Fed doesn’t have to return to zero interest on excess reserves. They can reduce the rate to .001%. That will keep the authority & precedent well established while reducing short term rates by 0.249%. Better than doing nothing.

    BTW: What does ‘fairness to banks’ have to do with monetary policy??

  2. Jeff Jensen says:


    Given the small amount of equities held by the average household, and with most of those held in retirement plans, how could the Fed purchasing domestic equities help the economy? Those who benefit don’t really need more income to spend anyway.

    We need to get money into the hands of those who need it and will spend it. The Fed and Admin need to work together to eliminate the FICA tax, and refund it directly to those who can use it! Monetary policy alone is not going to get our economy moving again.

  3. john putzivokium says:

    Why would anyone want to buy a house now when the trend has been for lower housing prices and the promise by the Fed is for lower interest rates until 2014? It doesn’t take a Bernanke (but maybe it should) to figure out that every day that goes by is another day that current homeowners experience more financial distress because they know they can’t sell their homes for a myriad of reasons. Sellers are caught between a rock and a hard place and the Fed is a major reason they’re there. Historically, we have had increased demand for homes typically when either the buying market believed home prices or mortgage rates were going up and this just isn’t in the cards while Bernanke is at the wheel. As long as he keeps the faith going that interest rates will be at all time lows we will just keep getting more of the same. There has to be an incentive to buy or move up and the Fed is making sure that procrastination rules with the continual promise of historically low mortgage rates.

  4. Bob McTeer says:

    Big Ed
    Fairness doesn’t have to do with monetary policy per se, but it does have something to do with the health and viability of the banking system, the lack of which has been a problem.

    Stock prices are one of the more reliable of the leading economic indicators. All these things help or not “at the margin.” Not all have to be involved directly.

    I agree with you that the promise of low rates well into the future is no longer a good idea.

    Bob McTeer

  5. Vinz Klortho says:


    Stock prices are not a meaningful economic indicator if the increase in price is due to a manipulative increase in the money supply by the Fed. I think they are an outcome of a strong economy, not the driver of a strong economy, so buying them to increase their price seems pointless.


  6. Stephen Grossman says:

    Central banking is socialist and thus destructive. It counterfeits money and credit, the cause of the business cycle. Austrian economists are prominent here but Richard Cantillon knew this in 1755.