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The Fed is worried, but leaves policy on hold

(MoneyWatch) The Federal Reserve's monetary policy committee did not offer any bold new moves at the conclusion of its two-day meeting. The committee reiterated its plan to keep interest rates exceptionally low through the end of 2014, and noted once again its plan to extend operation twist, its attempt to lower long-term interest rates, through the end of the year. But despite falling short on both its inflation and employment mandates, and widespread speculation by outside analysts that the Fed would do more to help the economy, policy remains on the same trajectory it was on before the meeting began.

TheFed indicated that the economic outlook has worsened since its last monetary policy meeting, and that makes it more likely it will take further action at some point in the future if conditions don't improve. But the decision to maintain current policy for now will disappoint analysts outside the Fed who have been calling for the Fed to do more.

If the Fed does do more at its next meeting, it is likely to follow one of the two policies Chairman Ben Bernanke emphasized in his recent testimony before Congress. In those remarks, Bernanke indicated that if the Fed does ease policy further, it is most likely to either engage in an additional round of quantitative easing, or extend its forward guidance on interest rates beyond the current guidance that rates will remain low through the end of 2014. Both of these policies would reduce interest rates some, but with interest rates already at historic lows, neither of these policies is likely to have a large impact on the economy and many observers both inside and outside the Fed are calling for more aggressive, creative moves.

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One frequently mentioned policy is lowering the interest the Fed pays on reserves. The Fed currently pays interest of 0.25 percent on any required or excess reserves that banks hold, and many people outside the Fed are calling for the Fed to reduce the rate to zero. The idea is that this would give banks more of an incentive to lend money to businesses and consumers, and the increased spending that would result from an increase in loans would spur economic activity and speed the recovery.

However, this idea has come up before, and as I explained in November 2010, the Fed is unlikely to adopt this policy:

First, reducing the interest rate on reserves would potentially increase the supply of loans, but the supply of loans is not the constraining factor, it's the demand. Businesses already have large cash reserves they could use to fund new investments, but they aren't using the funds for this purpose and it's not clear how making more cash available will change that. Businesses need to feel more optimistic about the future before they will make new investments, and until that happens making more funds available won't do much good.

Second, a quarter of a percentage point is not much of a disincentive to lending. Actual interest rates that consumers and businesses pay are higher than that, and rates have fluctuated by more than a quarter of a percent without a having much of an impact on investment and consumption.

Third, the Fed is unwilling to cutting the rate it pays on reserves to zero due to fears this would disrupt the federal funds market. Bernanke's argument is:

"The rationale for not going all the way to zero has been that we want the short-term money markets, like the federal funds market, to continue to function in a reasonable way," he said.

"Because if rates go to zero, there will be no incentive for buying and selling federal funds -- overnight money in the banking system -- and if that market shuts down -- it'll be more difficult to manage short-term interest rates when the Federal Reserve begins to tighten policy at some point in the future."

Cardiff Garcia at FT Alphaville has an extended discussion of this argument, but the main point is that Bernanke is not in favor of this policy and he has not said anything to indicate he has changed his mind since he made these remarks. If the economy continues to stagnate, this policy could still happen when the Fed meets next, but it seems unlikely. It is more likely that the Fed will remain within the parameters Bernanke emphasized -- more quantitative easing or more forward guidance for interest rates.