The release of the minutes of the most recent Fed meeting reveals the sharp disagreement among members of the FOMC, particularly between some Fed presidents and members of the Board of Governors. What can and should the Fed do given the weakness of the economy? Let's first look at whether it should implement QE3 (large scale purchases of securities). The benefits of QE3 would be reducing long-term interest rates further with the hope of stimulating lending and spending. The extra liquidity may also reduce risk premiums (extra interest paid by those without stellar credit; i.e., those with good credit, but not excellent credit); risk premiums on Baa corporate bonds have risen to 3.25% recently, which is the highest since the financial crisis and higher than any non-recession period. Arguments against QE3 include the limited effect that it will likely have on the real economy. The main effects of QE2 were a sizeable increase in bank reserves with little of the new funds making it into the economy. Many blame QE2 for increases in commodity prices, though there is some debate about this (other factors clearly contributed to increases in oil prices such as the Arab Spring, growth in the global economy, particular China, etc.). QE3 would likely encourage more speculation and lead to some increase in commodity prices, which is harmful to the economy. Overall, the potential costs of QE3 exceeds any benefits at this time. What would need to happen to justify QE3? There would need to be a serious concern of deflation, as there was in 2008. As of now, market-based forecasts of inflation are neither high nor low; the break-even inflation rate on 5-year Treasuries are just over 1.6%. So financial markets don't think inflation is going to be high any time soon, but also don't anticipate deflation.
Much of the weakness in the economy is beyond the control of the Fed, so it should be cautious in implementing any new stimulus. Options available include reducing interest rates on reserves (currently 0.25%, higher than other short-term interest rates), which may provide some incentive for increased bank lending. Something similar to operation twist from the 1960s is possible (increasing the Fed's holdings of long-term bonds while reducing holdings of short-term bonds by the same amount), but is likely to have a limited effect. It should be remembered that without any change, Fed policy is still quite stimulative. The federal funds rate at about 0.15%, below all measures of inflation (whether core of overall), resulting in negative real interest rates. Also, the Fed is maintaining a very large balance sheet ($2.65 trillion) and is reinvesting interest earned each month in new bond purchases.
So what should the Fed do? Barring significant economic decline and deflation, QE3 is not appropriate. Given current and expected economic weakness, continuing its current, highly stimulative policy seems to be the best course of action. However, it's unlikely to result in strong economic growth any time soon (factors beyond the control of the Fed will keep the economy from growing much for the foreseeable future).
