The question is expected to dominate the agenda when the Fed’s policy-making committee meets next week, with some members pushing for immediate action while others seek to delay a decision at least until the committee’s next meeting in September, so they can see a few more weeks’ worth of economic data.
The Fed’s chairman, Ben S. Bernanke, told Congress last week that the options under consideration included a new round of asset purchases, or “quantitative easing,” often described as QE3. As part of any such program, officials increasingly favor expanding the Fed’s holdings of mortgage-backed securities for the first time since 2010.
Mr. Bernanke and other Fed officials are convinced that such a step would further drive down long-term interest rates and improve the pace of economic growth, but they are concerned that the benefits would be modest and the costs uncertain.
The Fed also could take the smaller step of extending its forecast that short-term interest rates would remain near zero beyond late 2014, but many economists regard such a step as unlikely to provide a significant jolt to growth.
Any significant action by the Fed will reverberate in a presidential election that may be decided by the health of the economy. Republicans have urged Mr. Bernanke to refrain from taking additional steps, arguing that the costs were likely to exceed the benefits, while Democrats have pressed for a new round of stimulus.
Officials increasingly say that the economy has lost momentum after stronger growth earlier in the year. The unemployment rate fell by a full percentage point, to 8.1 percent, between September and April, but it has since made no further progress. Fed officials predicted in June that if they did not take further action, the rate would remain at or above 8 percent for the rest of the year. Fed officials are also concerned about the continuing crisis in Europe and the impact of substantial tax increases and spending cuts at the end of this year.
Mr. Bernanke has said repeatedly that the Fed would act if it concluded that the economy would not grow fast enough to reduce the rate of unemployment.
“We are very committed to ensuring, or at least doing all we can to ensure, that we continue to make progress on unemployment,” he told Congress last week.
For the Fed, there is a caveat that holds the key to understanding its pending decision. Current economic conditions would most likely warrant a cut in the Fed’s benchmark interest rate. But of course the Fed cannot cut that rate, which has hovered near zero since late 2008. Instead it must decide whether to try improving the economy by other means.
There is considerable evidence that the Fed’s purchases of Treasuries and mortgage-backed securities have reduced interest rates and encouraged investors to buy riskier assets like equities. Stock markets rally whenever the central bank hints at another round of purchases. The Fed has made two large rounds of asset purchases, first in 2008 and again in 2010. But the broader benefits of lower rates have been tamped down because many consumers and businesses are unable to qualify for loans.
Several Fed officials have expressed public support for buying mortgage-backed securities because studies show that such purchases have a larger effect on mortgage rates, allowing the Fed to take aim at the troubled housing market.
“If further action is called for, the most effective tool would be additional purchases of longer-maturity securities, including agency mortgage-backed securities,” John C. Williams, president of the Federal Reserve Bank of San Francisco, said in a speech in mid-July.
The uncertain costs of such purchases have created a higher bar for action. Some officials worry that the Fed will disrupt financial markets by acquiring too much of the outstanding volume of Treasuries or mortgage-backed securities.
“It would be helpful to have a better understanding of how large the Federal Reserve’s participation would have to be to cause a meaningful deterioration in securities market functioning, and of the potential costs of such deterioration for the economy as a whole,” Sandra Pianalto, president of the Federal Reserve Bank of Cleveland, said in a recent speech.
Other officials, however, play down this concern. The point of the purchases, in part, is to push investors into riskier assets. Mr. Bernanke told Congress last week that he recognized a theoretical limit on the amount of Treasuries that the Fed could own, but that he did not see it as an immediate constraint.
Another concern raised by some officials, and minimized by Mr. Bernanke, is that a larger portfolio could impede the Fed’s ability to respond to rising inflation.
The Fed’s purchases also have squeezed the premiums, in the form of higher interest rates, that investors normally demand to hold longer-term debt. As the distortion increases, so does the potential for disruption if premiums snap back toward historical norms.
And central bankers, cautious by nature and profession, also harbor wariness for the unforeseen risks of unprecedented actions.
Nonetheless, internal discussions have swung in the direction of additional action.
As recently as April, a majority of the officials on the Fed’s policy-making committee — there were then 17 members; there are now 19 — indicated that they no longer expected to hold interest rates near zero through 2014, as they had stated.
But the outlook deteriorated so quickly that at its next meeting in June, the Fed announced a holding action, extending to the end of this year an effort to modestly reduce borrowing costs by adjusting but not expanding its investment portfolio.
Fed officials have now made clear that they may make a move before that program ends in December. But they may wait past the meeting scheduled for next Tuesday and Wednesday. While the government will release its estimate of second-quarter growth on Friday, postponing a decision until the Fed next meets in September would allow officials to consider two more months’ worth of employment data.
By the time Bernacke writes a book of this time, no one will be able to afford it or he will be a 'tarred and feathered' figure and no one will need to read his words.
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