Fed Readies for Balance Sheet as Main Tool as Rate Nears Zero

Discussion in 'Wall St. News' started by rubibond007, Dec 16, 2008.

  1. By Craig Torres and Steve Matthews.-

    Dec. 16 (Bloomberg) -- The Federal Reserve may today reduce its main interest rate to the lowest level on record and prepare for one of the boldest experiments in its 94-year history: using its balance sheet as the key tool for monetary policy.

    The Fed’s Open Market Committee will probably cut the benchmark rate in half, to 0.5 percent, according to the median of 84 forecasts in a Bloomberg News survey. The central bank may also signal plans to channel credit to businesses and consumers by further enlarging its $2.26 trillion of assets.

    Chairman Ben S. Bernanke plans new steps to combat the credit crunch and prevent the worst recession in a quarter century from turning into a depression. The danger is the Fed’s credibility could be hurt if policy makers don’t clearly communicate a new strategy of manipulating the supply of money, at a time when FOMC members have diverging views on the subject.

    “We expect the FOMC to leave the policy outlook open- ended,” said Louis Crandall, chief economist at Wrightson ICAP LLC, the world’s largest broker of trades between banks, in Jersey City, New Jersey. “The FOMC may have no choice but to muddle along for a while longer” because “there is no sign that a consensus on a new approach has begun to emerge,” he said.

    The last time the Fed detached money creation from setting interest rates was in 1979, when former Chairman Paul Volcker oversaw a violent upward move in borrowing costs. Dubbed the “Saturday Night Massacre,” the effort was aimed at reining in inflation, which exceeded 13 percent that year.

    Averting Depression

    Bernanke, a scholar of the Great Depression, indicated in a Dec. 1 speech that policy makers will need to focus on “the second arrow in the Federal Reserve’s quiver -- the provision of liquidity,” including options such as purchasing Treasuries to inject more cash into the economy.

    A formal commitment to expand the balance sheet would constitute “the most extraordinary policy approach we have seen” so far, said Brian Sack, a former economist at the Fed’s Monetary Affairs Division, who is now senior economist at Macroeconomic Advisers LLC in Washington.

    The FOMC, which began meeting in Washington yesterday, is expected to release its statement around 2:15 p.m. Originally scheduled as a one-day meeting, the Fed extended its gathering to two days to discuss options that go beyond lowering rates.

    Communication ‘Challenge’

    “This is really a great communications challenge,” said William Ford, a former Atlanta Fed chief who’s now at Middle Tennessee State University in Murfreesboro. “It is going to take some educational effort to elaborate on how these policy options would work” because “people don’t know how to interpret what they are talking about.”

    The FOMC, which first started targeting the federal funds rate in the late 1980s, has lowered its benchmark by 4.25 percentage points since September last year. The last time it cut the rate to 1 percent, in 2003, the U.S. had already pulled out of a recession. This time, the central bank sees at least another half-year of economic contraction.

    It’s unclear how specific the Fed will be in today’s statement in outlining options after exhausting rate cuts.

    Bernanke has repeatedly invoked emergency powers not used to since the 1930s and expanded the Fed’s credit to the economy by $1.4 trillion.

    “The main focus of the Fed’s effort will shift to credit policies aimed at reducing credit spreads and improving the flow of funds in financial markets,” said Mark Gertler, a New York University economics professor who has collaborated with Bernanke on research.

    Cause of Freeze

    Fed policy makers disagree over the primary cause of the credit freeze. Central bank plans to buy $200 billion in consumer and small business loans and $600 billion in mortgage-backed securities suggest they consider rates remain high on home loans and credit cards because banks are unwilling to lend.

    Yet banks may instead be reacting to a decline in the credit quality of borrowers, Richmond Fed President Jeffrey Lacker said in a Nov. 19 speech.

    Tumbling property values and stock prices have hammered consumers’ finances. The net worth of U.S. households fell by $2.81 trillion to $56.5 trillion in the third quarter, the biggest decline since records began in 1952, according to the Fed’s Flow of Funds report.

    “My reading of current conditions is that bank lending is constrained more now by the supply of creditworthy borrowers than by the supply of bank capital,” Lacker said in his speech at the Cato Institute in Washington.

    Yield premiums on asset-backed securities surged as forecasters predicted a worsening recession and the unemployment rate increased to the highest level since 1993.

    Yields on AAA credit-card bonds maturing in three years rose to a record 5.75 percentage points more than the one-month London interbank offered rate this month, JPMorgan Chase & Co. data show.

    “The little bit of stability we have had is because there is an impression the Fed has almost unlimited resources and has adopted a tactic of intervention,” said Ethan Harris, co-head of U.S. economic research at Barclays Capital Inc. in New York.