The US Federal Reserve Bank is committed to healing the economy by any means in its power, and may yet be called upon to reach into its toolbox once more.
Dennis Lockhart, president and CEO of the Atlanta Federal Reserve Bank and a member of the Federal Open Market Committee (FOMC), spoke in Hong Kong last night about the risk of Europe to the US recovery.
He outlined the pragmatic nature of the Fed's decisions since the 2008 crisis, emphasising that the central bank will keep all options on the table to meet the needs of the moment.
Although he believes the Fed's actions have contributed both to managing the 2008 crisis as well as helping the US economy to recover, he believes there is a risk of a European recession or credit crunch impacting it. Speaking in a personal capacity, and not representing the FOMC, he says he has placed a negative "tilt" on his outlook for the US.
That may require the Fed to consider a third round of quantitative easing, but he adds that the bar for such an action must be set high. It would require a shock that put US growth at risk or changed perceptions toward expectations of deflation.
A negative tilt does not mean he expects Europe to derail the US recovery – but it's a possibility. Lockhart mentioned headwinds for the economy, but a deterioration in Europe was the only risk he cited for the US recovery.
However, he does not think problems around Greece and its membership in the eurozone will ever be as severe as what markets faced in the wake of the Lehman bankruptcy. Lehman Brothers' collapse came as a shock to the markets and to central banks; the issues around the eurozone are well known, are a subject of daily attention from European monetary authorities, and European banks have been working to reduce vulnerabilities to a negative political outcome.
Given all that, Lockhart explained his thinking on the limits of monetary policy to an audience gathered by the Institute of Risk & Regulation – North Asia. In particular, with the federal funds rate at its lowest trading band of 0-25 basis points since December 2008, and having grown the Fed's balance sheet, is there any more the Fed can do?
The answer for now is to rely on communication with the market, to steer expectations in a positive way. For now, the Fed has three basic policies it can use: interest rates, use of its balance sheet (for asset purchases), and communication.
The Fed embarked on emergency loans in the wake of the 2008 crisis and slashed short-term interest rates to zero. During 2009 it scaled back emergency loans and replaced them with QE1, in which it purchased $300 billion of short-term Treasury bonds and $1.25 trillion of mortgage-backed securities. This was a liquidity measure that, in net terms, didn't grow the Fed's balance sheet.
QE2, launched in 2010, was different: it was a net expansion of the balance sheet from the purchase of $600 billion of Treasuries, undertaken to counter growing fears of deflation. Lockhart likens this to a more classic move by a central bank to maintain price stability.
The Fed's last major initiative began in August 2011, when the FOMC made explicit its view that zero interest rates would remain in place until at least mid-2013; later it said this would remain the case until the end of 2014. The Fed also announced Operation Twist, a program of purchasing long-term Treasuries while selling short-term ones. Lockhart characterises both the 'forward guidance' and Operation Twist as policies to push economic recovery and stimulate job growth.
Today, with mixed data on that recovery and employment rate, the Fed is relying on communication efforts to encourage growth. But policy actions must match circumstances, says Lockhart, eschewing an ideological, one-size-fits-all approach.