Federal Reserve Chairman Ben Bernanke said he’s open to another attempt by the Fed to stimulate the economy if growth slows and deflation looks like a risk again. Speaking before the House Financial Services Committee on Wednesday, Bernanke said, “I think we have to keep all the options on the table. We don't know where the economy is going to go.” Here’s a look at four of the paths the Fed could choose, as outlined by Bernanke, if the economy takes a turn for the worse:
1. Being more explicit about how long the federal funds rate will remain near zero and the balance sheet will remain expanded.
“Certainty” was a key word at the Financial Services hearing. Lawmakers reminded Bernanke that uncertainty was dampening economic growth in their districts. Defining the period in which the Fed plans to continue its highly accommodating monetary policies would add to investors’ certainty of the Fed’s efforts to support the economy.
2. Doing a third round of quantitative easing.
The Fed has already done two rounds of quantitative easing (QE) to inject money into the economy. During a QE period, Fed banks buy Treasury bonds and Treasury-backed mortgage securities with money created by the Fed.
The effect on the Fed’s balance sheet is substantial. The balance sheet, which is a gauge of Fed lending to the financial system, more than tripled from $870 billion before the recession to $2.9 trillion in June.
3. Increasing the average maturity of the Fed’s holdings.
By increasing the average maturity of its portfolio, say, from 3-year Treasury securities to 10-year, the Fed can pump more money into the longer-term market—helping to increase that all-important certainty going forward.
4. Reducing the 0.25 percent rate of interest the Fed pays to banks on their reserves.
Banks tend not to lend funds at rates significantly lower than what they can earn by holding reserves at Fed banks. Reducing the interest rate would encourage banks to lend money out rather than let it sit at the Fed and would put downward pressure on short-term interest rates more generally.
Which way forward?
Bernanke did not state a preference for one tactic over another, and reminded lawmakers that the Fed’s experience with the options was somewhat limited and "employing them would entail potential risks and costs.”
He urged lawmakers to raise the debt ceiling, warning that failure to do so could trigger “a huge financial calamity.” Addressing the country’s long-term fiscal sustainability through tax and entitlement reform would likely boost the economy in the short term, he said.