trowe-Sep14

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September 14, 2010

Alan D. Levenson, Chief Economist410-345-2067/[email protected]

Bolstering Fed Policy Stimulus with Enhanced Communications

• It would be premature for the Fed to initiate a new program of asset purchases next week; recent economicindicators speak more to a sluggish growth pace (in the context of diminished growth potential) than to a lossof momentum en route to a double-dip recession, and high–frequency business credit data suggest that theprevailing policy stance may be starting to gain traction.

• At the same time, the Fed could add to the stimulative thrust of its current policy stance by expanding itsforward guidance to include its balance sheet as well as the fed funds rate. Clarifying expectations of thefuture path of the Fed’s portfolio might encourage banks to deploy excess reserves more aggressively.

• The main risk in further asset purchases pertains to the rates that the Fed might have to pay to elicit demandfor reverse repurchase agreements and term deposits sufficient to facilitate fed funds trading at a non-zerotarget rate in the presence of an even larger balance sheet.

The Federal Reserve’s latest “Beige Book” survey of economic conditions indicated “continued growth innational economic activity during the reporting periodof mid-July through the end of August, but withwidespread signs of a deceleration compared withpreceding periods.” 1 Against this backdrop, nextweek’s meeting of the Federal Open MarketCommittee will likely include further discussion of the

1 “The Beige Book,” Federal Reserve Board, September 8, 2010.

“tools and strategies for providing additionalstimulus.” 2

Additional Fed asset purchases not yet in order

In our view, however, it would be premature to initiatea new program of asset purchases next week; theeconomy shows more signs of shifting to a somewhat

2 Ben S. Bernanke, “The Economic Outlook and Monetary Policy,”At the Federal Reserve Bank of Kansas City Economic Symposium,Jackson Hole, Wyoming, August 27, 2010.

Trend Toward Easier Lending Standards Signals Upturn in C&I BorrowingFigure 1

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30

60

9093 95 97 99 01 03 05 07 09 11

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Lending Standards, 6 quarters ahead, inverted (L)C&I Loans (R)

Source: Federal Reserve, Haver Analytics, T. Rowe Price



slower growth pace than of losing momentum enroute to a double-dip recession. Nor are we convincedthat further asset purchases will be forthcoming overa longer time horizon, in part owing to evidence thatthe prevailing policy stance may be starting to gaintraction. For example, the turn toward banks easingstandards for commercial and industrial loans signalsa cyclical recovery in this lending segment (Figure 1,page 1). Indeed, while the year-to-year growth rate isstill negative, recent data indicate an emerging troughin the stock of loans outstanding (Figure 2).

Two-channeled policy guidance would enhance thedegree of accommodation in the current stance

Fed Chairman Bernanke believes that, “the degree of accommodation delivered by the Federal Reserve'ssecurities purchase program is determined primarilyby the quantity and mix of securities the central bank holds or is anticipated to hold at a point in time 3 (italics added). If the FOMC shares this view, then itcould increase the degree of accommodationdelivered by the Fed’s current portfolio size and mixby clarifying market participants’ expectations of itsfuture path.

Depository institutions might be encouraged todeploy excess reserve balances more aggressively if they were assured that they were not going to findthemselves suddenly short of liquidity if, say, the Fedreverted to a policy of allowing its securities portfolioto shrink with the return of principal from GSE-related securities. For (an admittedly simplistic)

3 ibid.

example, based on an earlier majority view in favor of deferring asset sales until after rate hikes havecommenced, 4 the Committee could expand its policyguidance as follows to incorporate both the interest rateand balance sheet instruments currently in use:

“The Committee will maintain the target range forthe federal funds rate at 0 to ¼ percent and continues

to anticipate that economic conditions…are likely towarrant exceptionally low levels of the federal fundsrate and an enlarged, diversified [not Treasury-only]securities portfolio for an extended period.” 5 (Sample expanded policy guidance in italics.)

The risk in additional asset purchases: paying up tomanage an even larger balance sheet

Bernanke and others have conceded that the impact of securities purchases in the current environment is likelyto fall short of that observed when markets were lessliquid and term premiums were unusually high. Thus,“the expected benefits of additional stimulus from

further expanding the Fed's balance sheet would have tobe weighed against potential risks and costs.” 6

In our view, the most prominent risk is associated withthe increase in the size of the balance sheet that the Fedwould carry into the inevitable – if distant – ratetightening cycle. The Fed currently carries over $1trillion of excess reserves on its balance sheet, virtuallyall of which would have to be prevented from enteringthe fed funds market in order for the Fed to facilitatetrading near a non-zero target rate. While the authorityto pay interest on excess reserves is an important tooltoward this end, the Fed developed supporting capacity

– the ability to issue reverse repurchase (RP)agreements and term deposits – to capture liquid assetsheld by nonbank intermediaries that are not eligible tohold reserve deposits at the Fed. For example, GSEs andmoney market mutual funds held $176 billion and $440billion, respectively, in fed funds and securities RP atthe end of the first quarter.

Presumably, the Fed will have to offer a rate slightlyabove the target funds rate in order to stimulate demandfor potentially hundreds of billions of dollars of theseinstruments. The risk in another round of Fed assetpurchases is that the associated increase in excessreserve deposits spills over onto the balance sheets of nonbank intermediaries, requiring offsetting sales of reverse RP and term deposits, and potentially higherrates – in absolute terms and relative to the fed fundstarget – to elicit the required demand.

4 Minutes of the Federal Open Market Committee, April 27-28, 2010.5 FOMC Policy Statement, August 10, 2010.6 Ben S. Bernanke, “The Economic Outlook and Monetary Policy,” Atthe Federal Reserve Bank of Kansas City Economic Symposium,Jackson Hole, Wyoming, August 27, 2010.

A Turn in the Business Borrowing Trend?Figure 2

1200

1250

1300

1350

1400

Oct-09 Jan-10 Apr-10 Jul-10

$ B i l l i o n s

Commercial & Industrial Loans

Source: Federal Reserve, Haver Analytics, T. Rowe Price

September 14, 2010 T. Rowe Price U.S. Economic Perspective 2




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T. Rowe Price Economics Department, T. Rowe Price Associates, Inc.

Chief Economis t Associate Economist Research Liaison

Alan Levenson Jared Franz Linda Smith (410) 345-2067 (410) 345-7657 (410) 345-5782 [email protected] [email protected] [email protected]

100 East Pratt St., Baltimore, MD 212021-800-225-5132/www.troweprice.com

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