Bernanke’s Toolbox: Possible Actions For The Fed In 2011

As Chairman Bernanke and the boys at the Fed prepare for their big 2 day FOMC meeting next Wednesday the 21st of September we take a look at some of the tools left in the Fed toolbox.

While the press is full of talk over the Fed’s lack of available tools, Bernanke has outlined on numerous occasions a variety of monetary policy actions the Fed can take to avoid deflation. We run through some of the tools Bernanke outlines in a speech he made in 2002 (when he probably never dreamed he’d have to actually use them just 6 years later).[1]

1. Commit to a low cash rate

Done. We saw Bernanke earlier this year come out and state that the Federal Reserve would commit to maintaining short term interest rates at roughly 0% until at least 2013.

More? Theoretically the Fed could commit to a zero interest rate policy for however long it likes. However given the fact that the Federal Reserve has gotten economic forecasts completely wrong (do we really need to cite examples) it would be extremely stupid to commit to an interest rate for even further in the future.

2. Purchase long dated Treasuries

Done. As part of QE1 and QE2 the Fed purchased longer dated Treasuries to force yields down.

More? Well that’s certainly what a lot of commentators and analysts out there are focusing on (and have been for the past couple of months at least).

3. Announce an explicit ceiling on yields

Not Done. While the Fed has purchased longer dated securities it has never actually explicitly stated a ceiling on longer dated security’s yields. Bernanke sees the simple threat of a ceiling on yields as enough to push them down and avoid the Fed actually having to make any purchases. Of course one could argue that the only real tool a central banker has is that of a credible threat.

A very similar policy to explicit yield ceilings was actually in place prior to 1951 where bond prices were pegged as part of the Reserve Treasury Accord. During the period the fed actually never bought a lot of Treasuries and in 1945, 1951 and 2001 it had roughly 7%, 9.2% and 9.7% respectively of Treasury debt on its books.

4. Buy private securities directly

Debatable. This is basically printing money and buying securities from the private sector directly. Well there’s a pretty blurry line between what’s public and what’s private these days.

5. Offer loans to the private sector and accept collateral

Done. Many affirm that the Federal reserve is doing this in a bit of a sneaky way with it’s good friend the US treasury. Bernanke outlines the process as;

The Treasury issues debt (bought with money printed by the Fed Reserve), then uses the money to buy private sector debt including:

  • corporate bonds
  • commercial paper
  • bank loans
  • mortgages and Mortgage Backed Securities (MBS)

Well this is pretty much the government taking toxic debt off the hands of US banks.

Federal Reserve and Treasury Dance

Federal Reserve and Treasury Dance

6. Sell US Treasuries

The Fed can of course sell its US Treasury holdings just as it can buy more. This is exactly what is being proposed as part of the so-called Operation Twist. The Fed will adjust its portfolio by selling short-dated Treasuries and buying longer-dated Treasuries.

Why would the Fed do this you may ask? Well the ultimate goal of the Fed is price stability and to avoid deflation they want to get more money in the system. Money enters the system through banks. At the moment there is a trade that every bank is sitting on that they have no reason to get off. A borrow short, lend long trade on US Treasuries. This is a virtually riskless money making trade that the banks can put on unfathomable positions in.

Banks use their cash to put this trade on instead of lending it to the private sector and putting money into the system.

7. Lower the rate paid to banks on their reserves at the Fed

In the past decade the US started using a system more akin to the Australian Reserve system whereby US banks hold reserves at the fed and are paid an interest rate by the Fed.

The Fed currently pays 0.25% on reserves, they can lower that to nothing.

8. Targeting the US exchange rate

Debatable. Well you could say that during the GFC the Fed didn’t intervene in the forex markets like it seems is all the rage these days *cough* Swiss, Japanese *cough* , however what effect on the USD do they think all their money printing is going to have?

Bernanke does see this as a possible option stating “exchange rate policy has been an effective weapon against deflation” and that the US could buy foreign assets to (further) bring down the value of the dollar.

During the Great Depression we saw Roosevelt enact a similar policy whereby the USD/Gold rate was devalued.

This is an extremely interesting policy option because of the currency wars being conducted by central banks that has gained more attention in recent months. Against the backdrop of the eurozone debt crisis we’ve seen the euro plunge. In response we saw the Swiss central bank come out last month and incredibly set a ceiling on the CHF/euro rate. We’ve also seen Japan’s central bank increase it’s currency intervention in forex markets this year. The big story however lies with China. Just this week we’ve seen statements from Chinese officials stating that they’re willing to buy eurozone debt. The Yuan/Euro, which isn’t pegged, has strengthened in recent months and China undoubtedly fears a drop in export competitiveness.

What’s more interesting however is the mounting political pressure from the US that China needs to revalue its currency so that the US can regain some export competitiveness. Could we see the Fed try to intervene in the FX markets if China fails to revalue it’s currency? Could Bernanke resort to one of the only tools he hasn’t tried?

Add to this Tim Geitner’s recent talks with European leaders this week and the urgency he has expressed in getting the Eurozone crisis under control and you could speculate about the US buying Eurozone bonds.



Deflation: Making Sure “It” Doesn’t Happen Here, Remarks by Governor Ben S. Bernanke, Before the National Economists Club, Washington, D.C., November 21, 2020