FED NEED TO BRING OUT ITS BIG GUNS AT JACKSON HOLE / THE FINANCIAL TIMES ( A MUST READ )

August 19, 2011 7:05 pm

Fed needs to bring out its big guns at Jackson Hole

By Dan McCrum


In the Bavarian region of Chiemgau, Germany, local shoppers can pay for their würstsalat lunch with brightly coloured Chiemgauer notes. Invented by an economics teacher in 2003, the money loses 2 per cent of its value every three months, funding the scheme, but also providing a helpful incentive to spend.


A similar plan for the US, some sort of tax on notes and coins, is just one of the more radical ideas being tossed around as a way for Ben Bernanke, the Federal Reserve chairman, to revive a sagging US economy.


After all, with the US government able to borrow money for two years at a cost of just 0.19 per cent, savers are already losing money to inflation at a steady pace. Although, were Mr Bernanke to take such a dramatic step, it would prompt calls of treason from more than just Texas governor Rick Perry, the presidential hopeful who warned against printing money from the campaign trail this week.


But, as the world’s central bankers prepare to head for their mountainside retreat in Jackson Hole, Wyoming, next weekend, it is becoming increasingly clear that Mr Bernanke needs to take some more radical form of action.


The announcement on August 9 that short term interest rates would remain close to zero into 2013 prompted the S&P 500 to rise for six days, but also served to reinforce the danger posed by a long stagnation.


Interest rates are already so low that businesses and consumers may come to expect years of stagnation ahead. If so, the US will have become like Japan, in its 17th year of deflation.


Investors are already worried by the lack of immediate solutions to global problems. Stock markets have tumbled largely on concerns over the US economy, the lack of a clear plan for Europe and the unanswered question of how fast China can grow in the future.


So heavyweight tools are required, and soon. Mr Bernanke last month laid out three options: changing the Fed’s language to be more explicit, as he has now done; buying more securities to add to the $2,700bn already on the Fed balance sheet (from $790bn before the financial crisis); and exchanging maturing debt for longer dated bonds to push long term interest rates down further.

Credit Suisse has also outlined more radical options. The Fed could cut the rate of interest it pays on balances kept at the Fed by banks to encourage lending, although the effect is thought to be slight: the lack of willing borrowers is the main problem.


It could step in to provide liquidity by lending directly to stressed sectors or directly to credit markets, as it did during the financial crisis. But this is only allowed during times of financial crisis. Or it could follow the example of the Bank of Japan by making longer term loans to banks.


The Fed, under “unusual and exigent circumstances”, might also lend directly to small businesses as it did during the Great Depression, an act that would be a boldly political challenge to a Congress that seems focused on cutting the deficit even as investors cannot get their hands on enough US Treasuries.


The clamour for US T-bills pushed 10-year yields to a 61 year low on Thursday, allowing the government to borrow at the cheapest rate in over half a century. Yet in the wake of the rancorous debate to raise the debt ceiling any chance of the Federal government increasing spending or cutting taxes as part of a new stimulus package for the economy seems remote.


So the essential thing is that the Fed does act. By explaining the tools available at Jackson Hole last year, Mr Bernanke prepared investors for the bond buying that followed, injecting confidence into markets that itself formed part of the stimulus.

For if the Fed’s next measures are to work as the effects of QE2 fade, markets must still believe that the Fed has power to influence the economy by use of its balance sheet. The longer that Mr Bernanke waits to act, the greater the risk that his power evaporates.


It may be too late already, in which case perhaps only a gamble in the mould of the Bavarian schoolteacher remains: set a timetable for rates to rise, making it expensive not to borrow, and encouraging immediate spending.


Copyright The Financial Times Limited 2011.