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10 10 2015 | by Victor Xing | Central Banks

What monetary tools can the FOMC use to fight the next recession?

With rates at zero lower bound, what policy tools can the Federal Reserve use to counter the next economic recession?

The available monetary policy tools to counter the next recession are as follows:

  1. Rate cut, assuming rates are no longer at zero lower bound.  Negative rate is out of question at this point, with the uber-dovish Minneapolis Fed President Kocherlakota being the only supporter (and he will step down in 2016)
  2. Restart QE purchases.  The new LSAP can re-focus on Mortgage-backed security, long-term Treasury notes and bonds, or Agency debentures (in reality, the agency debt market is too shallow and won’t make much of a difference)
  3. Use forward guidance to pledge keeping rates low for an extended period into the future, to induce financial markets in easing financial conditions on behalf of the FED
  4. Extend the SOMA Principal Reinvestment Program for longer.  This program is facilitating on-going bond purchases by reinvesting principal payments from bonds held on FED’s balance sheet, and it is currently expected to discontinue “sometime” after the initial rate hike

The Federal Reserve briefly touched on point #4 in its September FOMC Minutes, released on Thursday Oct 9th (this is new information)

The Minutes indicated that the System Open Market Account Holdings (i.e. the FED balance sheet) principal reinvestment program may be allowed to go on for longer to “help manage potential risks,” instead of ceasing sometime after rates liftoff.  In doing so, “several” policymakers argued, this would reduce the need to cut rates back down to the zero lower bound.

“Some” policymakers also made a case that if economic conditions deteriorate (or during the next recession), the Federal Reserve can simply restart the reinvestment program even after it has already been stopped.

SOMA maturities – the low-intensity QE that is still on-going

Maturities of Federal Reserve System Open Market Account (SOMA) holdings
Maturities of Federal Reserve System Open Market Account (SOMA) holdings

September FOMC Minutes – section on SOMA reinvestment policy (please see underlined text)

System Open Market Account Reinvestment Policy
A staff briefing provided background on the macroeconomic effects of alternative approaches to ceasing reinvestments of principal on securities held in the SOMA after the Committee begins to normalize the stance of policy by increasing the target range for the federal funds rate. The briefing presented analysis that was based on an assumption that the cessation of reinvestments, once implemented, would be permanent. The briefing suggested that if economic conditions evolved in line with a modal outlook, differences in macroeconomic outcomes would be minor across approaches that ceased reinvestments soon after initial policy firming or continued reinvestments until certain levels of the federal funds rate, such as 1 percent or 2 percent, were reached. As a result, the appropriate path of the federal funds rate would be only modestly affected. However, if substantial adverse shocks occurred, continuing reinvestment until normalization of the level of the federal funds rate was well under way could help avoid situations that would warrant a larger reduction in the federal funds rate than perhaps could be accomplished given the constraint posed by the effective lower bound to nominal interest rates.

In the ensuing discussion, participants considered the advantages and disadvantages of alternative approaches to reinvestment. Participants referred to the Committee’s statement on Policy Normalization Principles and Plans, which indicates that the timing of the cessation or phasing out of reinvestments will depend on how economic and financial conditions and the economic outlook evolve. Several participants emphasized that continuing reinvestments for some time after the initial policy firming could help manage potential risks, particularly by reducing the probability that the federal funds rate might return to the effective lower bound. Some participants expressed a view that, in contrast to the assumption in the staff analysis, the Committee could choose to resume reinvestments if macroeconomic conditions warranted. At the same time, it was also highlighted that a larger balance sheet could entail costs, and that the Principles and Plans indicate that, in the longer run, the SOMA portfolio should be no larger than necessary to conduct monetary policy efficiently and effectively. The Committee made no decisions regarding its strategy for ceasing or phasing out reinvestments at this meeting.

Next article10 10 2015 | by Victor Xing | Capital Markets

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