The Fed's latest plan to boost the economy

Federal Reserve

(MoneyWatch) The economy is recovering and the Fed has policy on hold for the moment, but if further action is needed in coming months the central bank is discussing what to do. The most likely course of action is a new bond purchase plan similar to the "Operation Twist" policy that was launched in September and ends this coming June.

One thing that is clear from the latest discussion is that some members of the Fed are very worried about inflation. This is evident in the design of the bond purchase plan which mimics a key feature of the Fed's $400 billion Operation Twist policy. Under Operation Twist, the Fed essentially removes long-term securities from the private sector and replaces them with short-term securities of equal value. Thus, this operation does not change the money supply, and hence does not change inflationary pressure.

There are two ways this can help the economy. First, if the Fed accepts risky long-term assets in exchange for lower risk assets such as T-bills, the amount of risk held in the private sector falls. The reduction in private sector risk hopefully makes individuals and businesses more confident and hence more willing to spend or invest. But the main effect comes through a second channel, the impact on long-term interest rates. The reduction in the supply of long-term assets in the private sector puts downward pressure on long-term interest rates and, although there isn't that much room for long-term rates to fall, any reduction could spur new spending and help the economy (and there's evidence that it does help, albeit modestly).

The difference between Operation Twist and what the Fed is discussing now, a policy known as a sterilization, is a bit technical but the essence is easy to grasp. Under Operation Twist, the Fed sells short-term assets off of its balance sheet and then uses the cash it raises from the sale to buy long-term assets. Under the present proposal, the Fed would borrow the money from the private sector in what is known as a reverse repo, and then use the money it borrows to purchase long-term assets. The loans from the private sector are short-term, and the Fed continues to roll them over until the longer term assets mature (or it can sell the long-term assets back to the private sector before they mature). Notice that, once again, the money supply doesn't change and hence the inflation risk is avoided.

Why do it this way instead of simply repeating Operation Twist? The main reason is that the Fed is running out of short-term securities -- it doesn't have enough left to do another round. The sterilization program avoids this problem by creating a different type of short-term asset, a short-term loan. Instead of selling a piece of paper to the public labeled "bond" as in Operation Twist, the Fed gives the public a piece of paper that is an IOU -- a loan -- and those loans can be made in practically unlimited amounts.

The essence of all this complication is to avoid inflation risk, but it's not at all clear that the Fed should be concerned about inflation at this time. In fact, Fed Chairman Ben Bernanke has stressed that he does not think there's much of a risk at all. And a temporary increase in inflation -- with an emphasis on the temporary part -- could spur firms to increase consumption and investment, precisely what we need to spur the recovery. One contingent on the Fed, the dovish contingent, agrees with this and would like to see more aggressive action. However, another contingent, the inflation hawks, are very concerned about the inflation risks from policies to date. The new policy under discussion at the Fed is an attempt to lean toward the dovish side -- to do something to help the economy -- without causing the inflation hawks to block the action. Nevertheless, it's very unlikely the Fed will take further action unless the economy stalls out or reverses course, or deflation fears reemerge.

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