Fed Will Ease Monetary Policy

¹²Fed Will Ease Monetary Policy: Economist

By Patrick Allen | 2 August 2010

Japan's Nomura has become the first investment bank to predict the Federal Reserve will begin to ease monetary policy following the recent slowdown in growth in the world's biggest economy. The deterioration in expectations for growth and inflation argues for an easing of monetary policy, Paul Sheard, the global chief economist at Nomura, wrote in his latest report. "We expect the Fed at least to stop the passive contraction of its balance sheet," he added.

Pushed by lawmakers last month, Fed Chairman Ben Bernanke outlined three ways the Federal Open Market Committee (FOMC) could further stimulate growth. First, Bernanke indicated he could change the Fed's language to convince the market it will not allow deflation. Second, the FOMC could endorse a decision by the Board of Governors to lower the interest rate it pays on required and excess reserves.

And the final option would be for the FOMC to restart the asset purchase program that ended in March. For any of these actions to be taken, it would have to become clear that the recovery was no longer sustainable, according to Bernanke. Last week, Federal Reserve Bank of St. Louis President James Bullard told CNBC that the central bank needs a plan for more 'quantitative easing' if the situation will require it.

Stop Shrinking Balance Sheet

But action should be taken before it becomes obvious the recovery is likely to falter, according to the Nomura economist. "Perceptions about sustainability are not binary, but lie along an unobservable continuum. A concerned and forward-looking policymaker would presumably take action some time before the economy had irreversibly slipped from sustainability," Sheard wrote.

"We now believe that current conditions have moved policymakers into action and that the FOMC will adopt a more accommodative stance at its 10 August meeting," he added. The Fed is likely to stop shrinking its huge balance sheet for the moment, a subtler form of easing than just buying assets again, according to the research. Sheard said that the Fed's current stated policy is to allow the redemption or pre-payment of agency debt and mortgage-backed securities to shrink its balance sheet.

"To the extent that the size of the Fed's balance sheet matters, this, in effect, amounts to a gradual tightening of monetary policy. Further shrinkage of its asset holdings now seems inappropriate in light of downside risks to growth," he explained. "We therefore think the committee will return to the explicit language of early 2009, in which it articulated a commitment to 'keep the size of the Federal Reserve's balance sheet at a high level,'" he added.

"Whatever the precise form of easing, action would send a strong signal to the markets: the Federal Reserve has many tools available at its disposal and will not hesitate to use them if it looks like it is not meeting its full employment and price stability objectives," Sheard also said.