Here’s What Fed May Do Instead Of QE3

The Federal Reserve sent some strong messages in its latest policy statement that it is heading toward new easing measures to buck up the weak economy. But the central bank may have a different caliber of weapon in mind other than launching another round of large-scale asset purchases, or QE3.

Economists on Wall Street get paid big bucks to understand the carefully worded statements of the Federal Open Market Committee meetings. In its August statement, the Fed said it will "closely monitor" the economy and "will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions." That's all Fed-speak for "we'll move if growth and employment don't show signs of improvement soon."

So far this year, the Fed has taken steps to support the economy at two of its five FOMC meetings. Market participants expect policymakers to give another nudge to economic growth at the Sept. 12-13 meeting.

However, investors might not be getting the widely anticipated QE3, as it could be voyage to nowhere.

Fed Chairman Ben Bernanke in his recent semi-annual testimony to Congress identified the "still-tight borrowing conditions for some businesses and households" as a major headwind.

So any new action from the Fed should be designed primarily to boost credit to households and businesses, with the aim of stimulating the recovery in housing and overall economic growth.

It is true that QE3, particularly if it focused on purchases of mortgage-backed securities, would probably help to lower mortgage rates a little further. However, mortgage rates have been falling for almost four years without any sign of a corresponding rebound in mortgage applications for home purchase.

"Under those circumstances, it seems unrealistic to expect QE3 to achieve what QE1 and QE2 conspicuously failed to deliver," Paul Ashworth, chief economist at Capital Economics, wrote in a note to clients.

Economists feel that the best option for the Fed to achieve its goals would be a cut in the interest rate payable on excess reserves combined with the launch of a new "Funding for Lending" program, whereby the Fed might provide cheap short-term loans to banks in exchange for guarantees they will resume lending to individuals and firms.

The Fed's latest Senior Loan Officer Survey showed that in the three months through July, demand for residential mortgages was particularly strong, with 53 percent of banks reporting an increase, up from 30 percent of banks in April and the highest figure since 1998.

But tight mortgage-lending standards remained unchanged in the three months to July. Therefore, there's a clear incentive for the Fed to adopt measures that loosen lending standards and allow more of this pent-up mortgage demand to translate into lending.

"We think that combining a cut in the interest rate payable on banks' excess reserves with a Funding for Lending scheme is more likely to achieve this than QE3," Paul Dales, senior U.S. economist at Capital Economics, wrote in a note to clients.

The central bank has been eyeing the British "Funding for Lending" for some time and Bernanke said in his June press conference that the committee was "very interested in it."

"Throughout the crisis, we've looked for new programs, new ways to help the economy. And this will be a type of thing that will be on the list of programs that we look at," Bernanke added.

The goal of this program is to boost bank lending to non-financial businesses and households by lowering the cost of funding for banks that engage in that lending. The program also provides incentives for banks to increase their lending.

So how does this plan work?

In the UK's case, the Bank of England is lending short-term government bills to banks, which use the securities as collateral to borrow money from the central bank at an ultra-low rate - about 0.25 percent - and then make loans to households and businesses.

The loans from the Bank of England will last for up to four years and any bank can borrow up to 5 percent of the value of its existing loan book, plus an additional one pound for every one pound increase in the size of its loan book between now and the end of next year.

For banks shrinking their loan books, an additional 0.25 percent penalty will be added for every additional 1 percent decline in that book, up to a maximum penalty of 1.5 percent.

"As well as offering clear incentives for UK commercial banks to boost their lending, one of the benefits of the scheme is that, as it only involves a temporary swap of securities, it won't boost the overall size of the Bank of England's balance sheet," Ashworth said.

The Fed ran a very similar scheme during the financial crisis called the Term Securities Lending Facility, which allowed primary dealers to borrow Treasury bills from the Fed for 28 days at a time in exchange for depositing eligible collateral.

However, installing a similar program is not without challenges.

For one, the Fed will be out of short-term Treasury bill and bond holdings when it wraps up its Maturity Extension Program, or Operation Twist, by the end of this year. The aim of Operation Twist is to push down long-term interest rates by selling short-term debt and buying longer-term notes.

That explains why Bernanke suggested the Fed could use its discount window to boost lending instead. Currently, banks can borrow overnight at the discount window at a penalty rate of 50 basis points above the Fed funds rate. At the height of the financial crisis, however, the penalty was 25 basis points and the Fed was making loans for up to 90 days.

To make the discount window appealing to U.S. banks, the Fed would need to cut the penalty rate and/or extend the duration of the loans.

Ashworth, at Capital Economics, noted that if the Fed adopted the plan, the loans would boost the size of the Fed's balance sheet by up to $300 billion. Although the increase would be relatively modest given that the balance sheet is already close to $3,000 billion, it still won't be popular among Washington lawmakers.

"Nevertheless, it would make sense at a time when the demand for credit appears to be rising and banks are still tightening lending standards for some types of loans," Ashworth said. "As it stands, an FLS is obviously only in the early planning stages. But it will be interesting to see whether the idea develops more support at the Fed."

Meanwhile, the Fed can also lower the interest on excess reserves, or IOER. The rate payable on reserves effectively puts a floor under the actual Fed funds rate. Commercial banks have no incentive to lend those reserves to other banks for a lower return than they would get from the Fed given the added default risk.

The reserve requirement for banks is currently set by the Fed at 10 percent of liabilities. If any particular bank didn't have enough reserves to meet its requirement, it would be forced to borrow from another bank that had excess reserves.

The Fed currently pays 0.25 percent interest on both required and excess reserve balances. But by opening up a gap between those two rates, the Fed could provide commercial banks with an incentive to expand the size of their balance sheets, thereby transforming some of their excess reserves into required reserves.

Most commentators have suggested cutting the rate payable on excess reserves to zero and presumably leaving the required reserve rate at 0.25 percent.

But Ashworth thinks the Fed could go further by setting a negative rate on excess reserves -- charging banks to hold them. In theory, the Fed could also create the same incentives by raising the required reserves rate to 0.50 percent while leaving the excess rate at 0.25 percent.

The problem is that risk-averse commercial banks might opt to expand the size of their balance sheets by buying Treasury securities. This is where a complementary Funding for Lending program would help.

"Extending the maximum duration of discount window loans, while maintaining the same rate, would provide banks with a cheaper source of funding than is currently available in the interbank market," Ashworth said. "Those funds would provide banks with the means to expand the liabilities side of their balance sheets."