Calling on the Fed

What I would give to be a fly on in the wall at the Federal Reserve right now, where Ben S. Bernanke is probably doing a double take on Friday’s horrible jobs report.

CATHERINE RAMPELL

Dollars to doughnuts.

The Fed’s recently released minutes from its August meeting showed huge disagreements over whether more monetary stimulus — and what form of monetary stimulus — was necessary. Many of the members of the Federal Open Market Committee, which sets interest rates, said they wanted to do something to help the economy, like further expanding or rejiggering the Fed’s balance sheet or decreasing the interest rate paid for banks’ excess reserves. And some wanted to do nothing.

Dollars to doughnuts.

Ultimately members decided to pledge to keep short-term interest rates near zero until “at least mid-2013,” although there was clearly more appetite from some of the members for more easing. The committee even decided to stretch out its September meeting to allow more time for discussion of these issues.

Publicly Mr. Bernanke, the Fed chairman, has argued that government policy can and should play a significant role in helping the economy grow, but emphasized that Congress should be the ones to lead the way. Congress, however, is trying to tighten fiscal policy, which is the exact opposite of stimulus, and seems fairly entrenched in this view.

It will be interesting to see how this dismal jobs report, which didn’t even meet economists’ already very low expectations, affects the committee meeting. The Fed may not have much ammunition left, but perhaps this latest news will convince it to fire what bullets it has.

Many Wall Street economists, including those at Goldman Sachs and RBC Capital Markets, are now predicting that the Fed will announce a change in the composition of its balance sheet so that it holds more longer-term assets.

How Much More Can the Fed Help the Economy?

With the risk of another recession on the horizon, many economists and investment analysts are hoping that Ben S. Bernanke will signal on Friday that the Federal Reserve is ready to step in once again and save the economy from disaster. After all, Congress seems wholly unwilling to engage in fiscal stimulus, and instead is planning further fiscal tightening.

But there are reasons to believe the Fed’s remaining tools may be losing their potency.

Monetary policy works best when the Fed cuts interest rates, giving banks a good opportunity to extend more loans. If more loans go out to people and companies, those people and companies can buy more goods and services, creating more demand and eventually more jobs.

CATHERINE RAMPELL

Dollars to doughnuts.

Interest rates are already at zero, though (and have been for a while), so the Fed cannot lower them any further. That’s why the Fed has engaged in more unusual — in some cases, unprecedented — measures.

Dollars to doughnuts.

Twice now the Fed has engaged in large-scale asset purchasing, a process known as quantitative easing. (Hence the nicknames QE1 and QE2.) This is meant to lower long-term interest rates, which should, in theory, stimulate economic growth in two ways.

First, it should encourage more borrowing, so companies and consumers will have more money to spend.

Second, lower long-term interest rates could encourage investment in riskier assets, like stocks. Why? Because if long-term Treasuries don’t offer much in the way of returns, investors will seek higher yields 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.

But this two-pronged attack is probably less powerful today than it was three years ago.

After two rounds of quantitative easing, long-term interest rates are already quite low. It is not clear that lowering them further with a third round of quantitative easing (QE3) would do a whole lot more to encourage investment in riskier assets, or to increase lending. Many companies are choosing not to borrow primarily because demand is so weak, and not because credit is expensive.

Additionally, if investors do start increasing their investments in assets with higher yields, 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.

And many economists are still debating whether the last round of quantitative easing was terribly useful.

“It’s hard to make the argument that QE2 was a rousing success or we wouldn’t be on the verge of seeing QE3,” the economists at RBC Capital Markets wrote in a client note. “The market may very well get what it seems to desire, but we believe there is no magic bullet here.”

There are other measures the Fed could take besides quantitative easing. These include changing the composition, rather than the size, of the assets already on its balance sheet so that they have longer maturities. Like quantitative easing, this could lower long-term interest rates, with many of the same pros and cons. There would probably be less political resistance to reconfiguring, rather than expanding, the central bank’s debt holdings.

The Fed could also lower the interest rate it pays banks on their reserves. Maybe this would encourage them to hold less cash and increase their lending. There is some debate about how effective this measure would be. If demand for credit remains low, encouraging banks to lend more may not be helpful.

Many economists have suggested that the most powerful tool the Fed might employ would be an announcement that it is raising 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. That is the much-sought-after virtuous cycle.

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. Not having a good sense of how much your next gallon of milk or gas will cost is stressful, particularly if your wages aren’t rising to match the higher prices.

Today inflation is pretty low, but it’s higher than it was a year ago when the Fed last engaged in quantitative easing. Already the more hawkish members of the Federal Open Market Committee are getting antsy. Since Mr. Bernanke cannot unilaterally carry out any of these stimulus strategies, the chances that the Fed will increase its inflation target in the near future seem low.

But hey, the Fed has surprised people before.