Nearly out of tricks, Fed may cut long-term rates

NEW YORK: News that the economy added zero jobs in August raises the chances that the Federal Reserve will announce another round of stimulus when it meets in two weeks, Fed-watchers say, most likely by pushing down long-term interest rates.

Cheaper credit could give the economy a boost - and prompt more hiring - by encouraging more borrowing, so companies and consumers have more money to spend. But with interest rates already low, it isn't certain how much this might help the economy, though proponents of more action by the Fed argue that this is better than not trying.

The central bank has already undertaken a spate of unprecedented measures to reinvigorate growth, including two large rounds of asset purchases. At its August meeting, many Fed policymakers expressed interest in engaging in further easing measures, but could not agree what to do. This dismal job report may spur them to action.

"I just don't think the Fed will sit idly as momentum fizzles in this recovery," said Dana Saporta, a US economist at Credit Suisse. "We fully expect some more action from the committee later this month."

The Fed is running low on ammunition though, and given political attacks on its accommodative measures thus far, its options are especially constrained.

As a result, economists predict that the Fed will change the composition of the assets on its balance sheet instead of expanding its size as it has in the past.

Right now the Fed holds about US$1.7 trillion (RM5.05 trillion) in US Treasury securities, of a vast array. Some mature in a few days and others in more than 10 years.

Many economists are guessing that the central bank will start selling off the ones that mature soon and buying up more treasurys that mature later.

Buying more longer-term treasurys increases the demand for longer-term issues. And as their prices rise, the interest rates on those securities fall as do many other interest rates across the economy that are pegged to the Treasury rate.

In addition to stimulating the economy with cheaper credit, lower long-term interest rates could encourage investment in riskier assets, like stocks. After all, if 10-year treasurys don't offer much in the way of returns, investors will seek higher returns elsewhere.

If investors do start buying up riskier assets, those asset prices rise. Consumers then see that their portfolios are worth more, causing them to feel richer and so more comfortable with spending. This is known as the wealth effect.

There are limits to how aggressive the Fed can be in swapping out short-term securities for longer-term ones. If it sells too many shorter term notes, then short-term interest rates will rise and the Fed has already promised markets that it will keep short-term rates near zero for the next two years.

Plus, after two rounds of quantitative easing and a worldwide flight to safety, longer term interest rates are already at historical lows of about 2 per cent. It is not clear that lowering them further would do much to encourage more investment in riskier assets or to increase lending.

"The cost of borrowing is not the problem," said Paul Ashworth, chief US economist at Capital Economics. "The problem is that there are not creditworthy borrowers, and that businesses don't want to invest because they're concerned about the economic outlook."

Additionally, if investors do start increasing their investments in assets with higher returns, they may pour more money into commodities like oil. And commodity prices are already higher today than they were a year ago; pushing energy and food prices further up could actually discourage consumers from spending.

Other options the Fed might consider include lowering the interest rate it pays banks on excess reserves to encourage them to lend more, but many economists doubt that this would have substantial effects on growth. A more aggressive option would be to raise its medium-term target for inflation.

If prices are expected to rise, banks, businesses and consumers will be more eager to spend their money before it loses value. That could have positive effects throughout the economy, since spending means more demand for goods and services, which means companies need to hire more employees, which means more spending and so on.

Additionally, inflation would lower the value of many people's debt burdens and so help with the painful process of deleveraging.

The problem, though, is that inflation has some major downsides, too - especially if coupled with sluggish growth, as seen during the "stagflation" of the 1970s. And some economists contend that raising inflation would only defer, not eliminate, the nation's problems.

Federal Reserve chairman Ben S. Bernanke stated in a speech last week that most of the tools that could be used to increase growth are "outside the province of the central bank."

In other words, Saporta said, "the Fed is putting the ball back in Congress' court." - NYT