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Fed Action Possibly Imminent, but It Looks Weak

Fed watchers are pointing to a change in language in yesterday’s Federal Open Market Committee statement that could signal a monetary policy action in September:

Central bankers led by Ben S. Bernanke concluded their two- day meeting Wednesday saying they “will provide additional accommodation as needed” to bolster the expansion. The Federal Open Market Committee also said it will “closely monitor” economic data and financial developments, suggesting it is focused on the economy’s near-term performance.

“The default is further easing,” said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut. “Unless things improve significantly, they’re going to move” at their Sept. 12-13 meeting, he said.

Previously, the language was more circumspect. Jon Hilsenrath, known as the “Fed whisperer,” said the same thing about this change, that it heralds imminent action. Goldman Sachs’ Jan Hatzius agrees, but doesn’t expect much boldness in the changes.

Our interpretation of the forward-looking language in today’s statement – especially the phrase “will provide additional accommodation as needed” – is that some form of monetary easing at the September 12-13 FOMC meeting is the current baseline. Although easing is by no means a foregone conclusion, we suspect that the incoming information needs to improve materially in order to forestall it. Under our own forecast of a only a slight improvement in output and employment growth, we believe a small easing step – most plausibly a lengthening of the forward rate guidance – is the most likely outcome for September 13, with asset purchases financed by renewed balance sheet expansion following in late 2012/early 2013.

I have several better ideas. The Fed could get into the muni market and relieve pressure on local government borrowing costs. They could implement Jeff Merkley’s plan by purchasing mortgages and facilitating refinancing for underwater borrowers, “injecting monetary policy into the heart of the economy,” as Merkley told me. Or, the Fed could follow Bruce Bartlett, and end the incentive for banks to hoard cash:

Banks must maintain a certain level of required reserves in the form of vault cash or balances at the Fed as a percentage of their deposits, in order to provide adequate liquidity. Reserves over and above those required are called excess reserves.

But rather than make loans, banks instead are simply sitting on the money, so to speak. According to the Federal Reserve, they have $1.5 trillion in excess reserves. This is extraordinary. It is as if individuals took $1.5 trillion of their savings out of stocks, bonds and every other income-producing financial asset and put it all into non-interest-bearing checking accounts back in 2009, and just left it there.

Economists have puzzled about this phenomenon for years. They note that historically the Fed never paid interest on reserves, but in October 2008 it began doing so. Moreover, the Fed pays interest on excess reserves as well as required reserves. Originally, the rate was 0.75 percent to 1 percent, but since Dec. 17, 2008, it has been fixed at 0.25 percent.

This may not sound like much, but keep in mind that interest rates on United States Treasury securities with maturities of less than two years are currently less than 0.25 percent. The effective fed funds rate is also lower than 0.25 percent. In recent weeks, it has been as low as 0.13 percent. Compared with these rates, a riskless return of 0.25 percent looks pretty good.

As Alan Blinder has encouraged, lowering or eliminating the interest rate on excess reserves would end the incentive for banks to store cash at the Fed. In fact the Fed could CHARGE banks for the privilege. That would force banks to use those excess reserves in some way. I’m not totally convinced that money would go into lending and not gambling, but it’s certainly worth considering. And it’s a damn sight better than the weak tea the Fed could have on offer in September.

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David Dayen

David Dayen