The Federal Reserve Pulls a New Lever

Since the financial crisis worsened in 2008, the Federal Reserve has acquired probably dozens of new options for influencing the U.S. and world economies, ranging from propping up the commercial paper market to buying mortgage-backed securities to lending dollars abroad in exchange for euros, yen, and other currencies.

The new options, most not currently in use, increase the Fed's flexibility but complicate the job of conducting monetary policy. They also make it harder to communicate that policy to investors and the general public. The risk of adding to uncertainty was apparent after the Federal Open Market Committee's Aug. 10 meeting, at which it announced that "the pace of recovery in output and employment has slowed in recent months." The Fed said that to keep the money supply from shrinking it would stop letting its bond portfolio get smaller. It will begin to reinvest the principal payments on mortgage-backed securities in the Treasury bond market so its overall portfolio of securities owned outright will be stable at a touch over $2 trillion.

Investors were hardly reassured. A day after the Fed rate-setters' meeting, the MSCI World index of global stocks fell by the most since June and the Standard & Poor's 500-stock index sank 2.8 percent. Some investors concluded that the Fed wasn't doing enough to spark growth. "We're in a worldwide soft patch, and investors wonder why the Fed didn't do more," said James Swanson, chief investment strategist at Boston-based MFS Investment Management, which oversees about $197 billion. "People are dumping stocks because they're afraid earnings will decelerate and the economy is losing steam." Others thought the Fed should have done less, not more: Dissenting for a fifth straight meeting was Thomas M. Hoenig, president of the Federal Reserve Bank of Kansas City, who felt deflation fears were overblown.

Marvin Goodfriend, a monetary economist at Carnegie Mellon University, said the effectiveness of the Fed's move was undermined by the vagueness with which it was announced. The Fed tersely stated that the reinvestment was "to help support the economic recovery in a context of price stability." Says Goodfriend: "If the actions are not placed in a context that allows the public to understand the follow-through, they lose punch."

The Fed's move isn't completely mysterious. The central bank is taking a middle path between letting its portfolio shrink, which would be a vote of confidence in the economy's health, and resuming big purchases of securities, which it would do if the economy got into deeper trouble. Life was simpler when the only lever to push was the one marked "fed funds."

The bottom line: New options have made the conduct of monetary policy more complex. The Fed's latest move may have confused some investors.

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