Markets have taken much comfort on news that the Fed could soon extend forward guidance in the manner of rate hikes and announce a third round of quantitative easing to bolster markets.
But the Fed has a whole host of tools at its disposal.
We drew on a Bank of America report to put together all the tools by likelihood of their near term use.
High near-term likelihood
- Extend rate guidance to "late 2015": The fed is likely to modify its statement to say that it will extend the exceptionally low level of the fed funds rate through late 2015. The objective is to lower front end rates and rate volume, but market reaction to this could be impacted by lack of credibility to Fed forecasts that reach 3 years into the future, since the rate guidance is subject to change. Moreover, Bernanke's term ends in January 2014, and other FOMC members might not be around to ensure that the Fed's rate forecast is maintained.
- QE3 (third round of quantitative easing): The Fed is expected to announce $300 billion mortgage backed-securities (MBS) purchases between October and June, and $300 billion in Treasury purchases after Operation Twist ends. The objective is to lower rates and boost risky assets but market implications will depend on how much of QE3 is priced in. This could however increase inflation expectations, impair liquidity in the bond market, and this could make the Fed's exit strategy more difficult i.e. make it harder for the Fed to unwind the purchases on its balance sheet.
- Refine communication tools: There is room to improve the Fed's communication tools which include the FOMC statement and the consensus forecasts of the voting members in the Summary of Economic Projections (SEP). "One weakness of this approach is that the SEP is based on the views of the whole Committee, including a number of hawkish nonvoting Presidents, while the statement comes from the voters only. This can confuse the markets," according to BofA analyst Priya Misra and her team. It will however be difficult to agree on consensus forecast / scenarios.
Low near-term likelihood
- Lower the interest on excess reserves (IOER): The Fed could lower the interest paid on excess reserves to 10 basis points or less, with the objective of lowering front-end rates. This could marginally lower short-term rates but risks impairing money market liquidity. It could also cause banks to charge customers for deposit, and money market funds could see large outflows. Many large European money funds for instance have closed for new investments because of the impact this could have on their investors.
- Discount window / funding for lending: Here, the Fed would provide long-term loans to the private sector indirectly via banks, against eligible collateral, through the discount window. It could also be a move similar to the Bank of England's "Funding for Lending scheme" where banks can swap loan collateral that is eligible under the discount window for treasury bills for up to 4 years. The objective here is to increase bank lending and lower credit spreads, but there is the risk that some banks could become too dependent on the Fed. Moreover this may be perceived as a bailout and banks might refuse to participate.
- Mandate targeting: Make policy 'state' rather than 'time' dependent. This would mean that policy would be a function of economic conditions instead of just expiring at a given time. The "triggers" needed for a change in policy would be simple and would not be used in "normal times". This is a large scale operation intended to improve financial conditions but it risks reducing policy flexibility.
Very low near-term likelihood
- Forex market intervention to weaken the dollar: The Fed could "act as an agent of the Treasury to weaken the dollar by open market Forex interventions," according to Misra. If it were to resort to this tool, the Fed would directly sell the U.S. dollar and buy currencies of other regions. This policy does face political challenges since Congress is against debasing the dollar. Moreover there is a real inflation risk if imports become expensive because of a weaker dollar.
- Impose a ceiling on yields: The Fed could commit to keeping Treasury or mortgage backed-securities (MBS) yields below a ceiling for a period of two years with the aim of lowering rates and rate volume. The Fed could do this for instance by announcing that it will buy Treasury securities. Bernanke has previously recommended this as a way to counter deflation but this is politically challenging, it would make the Fed's exit strategy difficult and could increase inflation risks.
- Raise the inflation target: An extreme tool at the Fed's disposal is to raise the Fed's long-run inflation target that has been pushed by the likes of Paul Krugman and the IMF's chief economist Olivier Blanchard. The objective is to stimulate the economy and encourage investment by decreasing real interest rates, while raising inflation expectations. This Fed tool is however likely to face political opposition since it would involve undoing inflation expectations.
- Money financed fiscal expansion: If the Fed were to draw on this tool, it would directly boost demand by increasing government consumption expenditures and could put money directly in the hands of those who spend it. This could also take the form of tax cuts, tax rebates, and money printing by the Fed. This approach does however risk raising inflation, and raises concerns that the government could force the Fed to resort to these measures even when such policy is inappropriate. The measure is also politically unfeasible given the stalemate in Washington about public debt and spending.
Please follow Money Game on Twitter and Facebook.
Join the conversation about this story »
Source: http://feedproxy.google.com/~r/TheMoneyGame/~3/m1nX4kN4sAo/fed-policy-tools-2012-7
Guide To Financial Fitness Money Game Tech Crunch Personal Finance News & Advice
Amazon just 
It looks like someone made the colossally silly decision to buy Mitt Romney Twitter followers. In just a few days earlier this month, Romney saw of a spike of 150,000 Twitter followers, and most of these likely fake accounts, had less than 2 followers themselves, according to some 
Stephen Elliott, founder and editor-in-chief of a literary website called