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The Fed has some tools left in its arsenal. Some of them are extremely unlikely, but considering them is especially interesting.BofA Merrill Lynch analyst Shyams Rajan recently wrote a report on all of the Fed’s remaining options.
Below are the four policies most unlikely, according to Rajan, to see the light of day – due to the controversies they would spark and the unintended risks they would bring.
Impose a ceiling on 10-year Treasury yields: Bernanke mentioned it in 2002 as a way to combat deflation, a word that seems to be rolling off tongues lately. BofA suggests, for example, that the Fed could put a two-year, 1.25 per cent ceiling on 10-year Treasuries in an “unrestricted commitment to expand the balance sheet.”
If that were the case, we would probably see yields “steepen considerably” on Treasuries with longer tenors (between 10 and 30 years), reflecting rising inflation expectations. This, in turn, could induce the Fed to “cap rates at multiple points on the [yield] curve.” Full stop rate management.
Raise the inflation target: Krugman is always suggesting it. Rogoff mentioned it on TV just this morning. Bernanke even recommended it to the Bank of Japan back in the day. However, BofA points out that he’s since changed his tune, writing that “Bernanke also suggested that it might be hard for a central bank like the Fed to easily unhinge currently well-anchored inflation expectations — and then, once doing so, it would also be hard to re-anchor them at, say, 4% without potentially drifting higher.” Cue hyperinflation.
BofA on how rates would react: “The net effect on nominal rates would likely depend on how aggressively the Fed set out to achieve a higher inflation target. If the Fed combined a higher inflation target with a ceiling on yields, it could drive real rates deeply negative.”
Money financed fiscal expansion: Banks aren’t lending out QE money, which means the economy doesn’t see the benefits of monetary easing.
BoA explains how the Fed could coordinate with the government to sidestep the banking system with new stimulus:
Instead of financing expansionary spending or tax policies through debt issuance or tax increases, the government would rely on seignorage (i.e., printing money). For example, the government thus could finance tax cuts — an expansionary fiscal policy — via Fed purchases of Treasuries funded by an increase in excess reserves.
Such a plan, given the current political dynamics within the U.S. government and also between the government and the Federal Reserve, looks like a nonstarter.
FX market intervention: An epic scenario – the Fed selling dollars against other currencies to explicitly weaken the dollar. This is typically the domain of the U.S. Treasury, which uses its Exchange stabilisation Fund to do that kind of thing as it sees fit. However, the Fed could get in the game too (section 14 of the Federal Reserve Act authorizes it to do so).
BofA says that “The question of what assets the Fed would purchase with its intervention proceeds is also relevant…the Fed has the statutory authority to purchase foreign currency-denominated government debt in unlimited quantities should it choose to do so.” They also warn that such a plan “could risk a competitive devaluation cycle with adverse geopolitical consequences.” All out currency war.