Finding itself in a bind, the US Federal Reserve has found it wise not to attempt QE3, but instead provide a stimulus to long-term finance, with a view to encouraging investment and growth. It has not minced words in its press release about the gloomy near-term prospects for growth for the US economy.
The Federal Open Market Committee decided to extend the average maturity of its holdings of securities of $2.65 trillion.
The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of six years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of three years or less. Thus, it is not creating money.
To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.
In addition, it will maintain its existing policy of rolling over maturing Treasury securities at auction. It has also decided to keep the target range for the federal funds rate at 0-0.25 per cent and currently anticipates that economic conditions are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
CHANGE OF STRATEGY
The aims of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Market Committee should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”.
Generally, in the recent past, the Fed acted at the short end of the interest rate spectrum because, due to the integrated nature of the financial system, changes therein influence long-term rates, such as those on Treasury notes, corporate bonds, fixed-rate mortgages, and auto and other consumer loans.
Long-term rates are affected not only by changes in current short-term ones but also by expectations about them over the rest of the life of the long-term contract.
The Fed announcement of a near-zero short-term rate till the middle of 2013 anchors expectations of a low rate regime for the longer term. Perhaps it is for the first time in recent years that the Fed has directly tried to influence the long-term rate.
One cannot say definitely that the Fed strategy will work. Having found that QE1 and QE 2 were not effective, it has wisely decided not to increase the size of its balance sheet further, having seen it bloat since the Lehman Crisis.
The problem is that there is no definite estimate available as to how much of each dollar created and spent in the US remains within the country and how much goes out for the import of raw materials, final goods, services, etc.
STIMULUS LEAKAGE
The Input-Output or Inter-Industry Tables of US should normally be able to convey this information. However, in the tables, intermediate inputs record the sum of imported and domestically-produced goods whereas the researcher needs separate data for them.
The ratio of import to export elasticities vis-à-vis US and world income, respectively, originally estimated to be 1.7 by Houthakker and Magee, seems to hold good even now, according to the available studies.
Under the circumstances, the Fed is right in not going for another round of monetary expansion that could only result in creating more employment and inflation in other countries than in US.
Further, the US citizen has found the virtues of saving after having gone through the miserable experience of foreclosures on home mortgages. The level of household saving was 2.1 per cent of GDP at the end of December 2000. It was 5.5 per cent at the end of June 2011 and 5.0 per cent at the end of July 2011.
Household debt in the US is estimated to be $13 trillion, of which home mortgages account for 75 per cent. It is a moot point whether there will be any further increase in this proportion in the near future.
One can only hope that a low mortgage rate will not lead to another sub-prime crisis.
The Greenspan policy of low rates has been blamed for the onset of the current financial problems following a boom in the economy.
IMPLICATIONS FOR INDIA
So far as India is concerned it is good that there is no further expansion in money supply in US, that could result in the inflow of footloose funds. The current trend of the depreciation of the rupee should also act as a dampener on such flows.
We hear appeals to the RBI by the affected parties to undertake market intervention to arrest the depreciation.
It means that the RBI will sell dollars to relieve the shortage of the currency and, in that process, absorb rupee liquidity at a time when the repo operations are at a high level.
Forex market intervention needs to be coordinated with the rest of monetary policy since it is also a part of Open Market Operations.
The reserves are close to the external debt. The RBI cannot engage in a sustained intervention that is required to stabilise the rate at some pre-determined level.
If it does, it will face the same prospect of a heavy loss of reserves, as happened to the Bank of Thailand ushering in the East Asian financial crisis in 1997.
It could be only a token effort, after which the exchange rate will be back to square one, as observed in many episodes of market intervention in other countries.
(The author is a Mumbai-based economic consultant. blfeedback@thehindu.co.in )