What the Federal Reserve can Do to Save the US Economy

The Federal Reserve Board’s open market committee have been tasked with what it considers to be its last opportunity to take action that will boost the economy before the end of the year. Whilst they actually meet up every six weeks, the FOMC have a historical reputation for being reluctant to make any major moves so close to an impending election. Using that premise as a guide to what moves they are likely to make, this month is the last window of opportunity to put something meaningful into place and take steps to boost the economy on an urgent basis. There can be little argument that the U.S economy just like many developed countries at the moment, is in desperate need of an injection of hope and optimism in the shape of positive measures and incentives. Despite the fact that an average rate of job creation of 165,000 per month over the first half of 2012 sounds reasonably impressive it is actually far too slow. The economy needs in the region of 100,000 new jobs a month just to keep up to speed with labor force growth and at the current rate it would take more than 12 years to recover from the 10 million jobs deficit that the poor global and domestic economic conditions have created to this point. If there is a clear need for more rapid growth, which there clearly is, economic data shows that there is little downside risk of excessive inflation. Many economists have argued that higher than normal inflation would in fact be desirable as it would reduce real interest rates in a market where the Fed has already pushed their nominal federal funds rate as low as it can possibly go. This would in theory provide business with a greater incentive to invest and higher inflation would have a positive impact on house prices enabling homeowners to repair their equity comfort zone and thus boosting confidence. The problem is that for good political reasons the Fed is very reticent to accept the idea of promoting higher inflation, ironically something that Chairman Ben Bernanke actually used to subscribe to when he was an economics professor!

So what steps can the Fed take to boost the economy that would be considered acceptable?

The first step would be to consider yet another round of quantitative easing, which effectively means buying up long-term debt via treasury bonds or mortgage backed securities in the hope that this will have the effect of driving down long-term rates even further. The Fed already owns something close to an eye-watering $3 trillion of mostly long-term debt so acquiring another $1 trillion or so could be done in the hope putting some downward pressure on rates, which if you take an optimistic view, could lower the 10 year treasury rate by as much as 15-20 points and in doing so, lower the value of the dollar and boost net exports, bring about an improvement on the trade balance.

The other path to consider would be to return to an idea that Bernanke outlined about three years ago, which would be to target a longer term rate. As an example, if the Fed set a target of 1.2% for 10 year treasury bonds, lower than the current rate of 1.5%, this would mean that the Fed would buy as many treasury bonds as required to bring yields down to this level.

This idea would have a similar impact on markets as quantitative easing but it could potentially have a more powerful and sustained effect that would produce lower mortgage rates and boost business confidence. Unfortunately neither of these ideas will actually turn around the economy at this point but some action is better than none and some estimates suggest that lower mortgage and financing costs could translate into a further 400,000 jobs. If the Fed buys more assets it will in turn generate more mortgage interest that is refunded directly to the treasury. This has a direct benefit on the economy and rather than cut funding for education and Medicaid, they instead buy a few hundred billion more of assets, that would seem a reasonably good political and economic reason to take action now while they have the opportunity.

Author bio: Guest post written by financial writer Elizabeth Goldman, on behalf of Earn Forex