In an article (subscription required) today in the Wall Street Journal, Jon Hilsenrath discusses what course the Federal Reserve’s monetary policy could take in the coming months.
Since spring of 2009 the Federal Reserve has pledged to keep interest rates low “for an extended period”. It did this in concert with an unprecedented stimulus package that saw the Fed purchase $1.25 trillion worth of mortgage backed securities in order to provide liquidity to the market and keep mortgage rates low.
For the last two quarters the economy has posted strong growth, and it seemed a fait accompli that the Fed would raise rates sooner rather than later. Now, there are signs that the economy is slowing, and inflation is falling below the Fed’s target rate. Although Fed Chairman Ben Bernanke’s recent comments have indicated that he is cautiously optimistic about the economy, if the recovery grinds to a halt, or deflation occurs, the Fed will most likely choose another course of action than to tighten monetary policy.
Hilsenrath lays out some of the different actions the Fed could take to combat an economic downturn:
- The Fed could continue purchasing assets such as mortgage-backed securities (MBS). This would serve to keep long-term interest rates low and would provide a degree of liquidity to credit markets. Mortgage rates are already near historical low points, so it is unclear how much effect this resumption of this policy would have.
- Rather than purchasing new MBS or other assets, the Fed could reinvest the money it receives when borrowers pay off the mortgages the Fed already holds. Again, this would inject money into credit markets and keep rates low.
- The Fed could strengthen its pledge to keep interest rates low. This would reinforce the idea that rates will remain low for quite some time, and would hopefully have an ameliorative effect on the markets.
The economy still faces severe headwinds to recovery, including high unemployment, a weak housing market, and a spreading debt crisis in Europe. It will be interesting to see what, if anything the Fed does at its meetings next week. Stay tuned.
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