Economy on the Brink--The Fed's Next Move

With the Fed meeting tomorrow, everyone wants to know what the Fed's next move after this dramatic crash. This is a re post of a previous article which explains the Fed's options during a liquidity trap.

1. Dramatically Change Price Expectations---Recent Fed announcements indicate that they want a 2-3% inflation rate compared to the current 1% rate. One idea is for the Fed to increase its inflation target upward to between 4-6%. To support this new policy the Fed could openly announce that they are monetizing debt rather than calling their money printing--credit easing. The Fed could also buy new kinds of assets such as stocks, corporate bonds, land, etc. This could have the effect of stimulating spending as consumers and businesses fear the loss of purchasing power. It would make it clear that the Fed is serious and will do everything in its power to create inflation.

2. Cap Treasury Rates (Aka. Operation Twist)--Under this policy option the Fed would agree to cap treasury rates at unreasonably low rates (e.g 10 year at 2.0% and 30 year at 3.5%). They would openly announce the target to the market and state that they will print as much money as necessary to achieve the goal. This would have the effect of lowering the real inflation adjusted yield of the 10 year to below zero. It would reduce the incentive for financial institutions to hold Treasuries and force them to do something with their money.

3. Taxing Currency---- Under this option the government would tax the currency, meaning that the dollar would automatically lose value over a period of time (say 3% every 6 months). This would create a cost to holding currency, giving people and institutions an incentive to spend it quickly, which would increase the velocity of money throughout the financial system. An extreme example of this policy would be the introduction of a new currency, which would lose a certain amount of value over a fixed period of time. The Japanese government considered this option in 1999, but never implemented it.

4. Negative Interest Rates--Like taxing currency, this option imposes a cost to hold money and theoretically forces people and corporations to spend money, which would increase aggregate demand. However, this is a hard policy to implement from a political perspective. It could lead to a flight of capital from the US as savers abandon the dollar for foreign assets. Under this policy option you may have to implement capital controls. What could work is for the Fed to impose negative interest rates on bank deposits held at the Federal Reserve. They could also prevent banks from passing along negative interest rates to consumers. Banks would be forced to do something with all of the money they are hoarding. This policy option would give banks an incentive to lend to the economy.

5. Reduce the Interest Paid on Excess Reserves---One reason QE failed was because banks simply held onto all of the excess reserves created by the Fed. All of this money is simply sitting around doing nothing for the economy. The Fed could reduce the rate it pays on these excess reserves, thereby creating an incentive for the banks to lend the money. While this appears to be a logical policy option, it is not practical because the major banks are largely insolvent. They need the capital to cushion themselves from future credit losses. Even if the Fed was to reduce the rate paid on reserves to 0%, it would not be enough to encourage the banks to lend out the money.

6.Extend Duration of Balance Sheet--Under this option, the Fed would start to move its bond holdings into longer dated Treasuries. The idea would be that the Fed would indicate to the market that it is going to maintain easy monetary policy forever. However, this action would be a de facto admission that QE 1, QE 2  was debt monetization. The last bit of confidence left in the dollar would collapse . The whole goal of QE was to con Americans and foreigners into believing QE was temporary and would be reversed at a later time (readers know better than that). If the Fed starts buying 30 year treasuries, it collapses the illusion forever.  

7. Helicopter Drop Money--The easiest way to stimulate aggregate demand is to print money and hand it out to the general population. Imagine everyone in the US getting a check for $25,000. This would automatically create inflation and increase spending. It would also increase inflation expectations, which the Fed considers important. The major drawback is that nobody knows how much inflation this would cause and it might lead to hyperinflation.

As you can see the Fed is not out of bullets. Zimbabwe Ben and his fellow counterfeiters will stop at nothing to create inflation and destroy the value of the dollar, all in the name of saving the economy.

Black Swan Insights

Economy on the Brink--The Fed's Next Move