Finance

3 Ways The Fed Could Boost The Economy

The Federal Reserve has already lowered a key short-term interest rate to just above zero. On top of that, the central bank bought more than $1 trillion worth of mortgage bonds in an effort to give the economy additional juice.

So, with economic growth still lagging and unemployment still high, is there anything else the Fed could do?

Yes, Ben Bernanke said in a big speech this morning. But it's not quite ready to use the additional tools.

Here's the key quote from this morning. It may not that dramatic, but it's a pretty big deal coming from a Fed chairman:

... the Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly.

Bernanke laid out three potential tools the central bank has been discussing.

1. Buy more bonds.

"I believe that additional purchases of longer-term securities ... would be effective in further easing financial conditions," Bernanke said.

When the Fed buys long-term bonds, it drives long-term interest rates down. That makes it easier for people and companies to take out long-term loans, which in turn stimulates the economy by encouraging more borrowing and spending.

One drawback to this approach, according to Bernanke: the Fed has very little experience with these sorts of purchases, so it doesn't have a precise understanding of how its purchases affect the broader economy.

Another issue: To buy more assets, the Fed would create more new money. That in turn could lead to worries about inflation. Bernanke cited these worries, but suggested that Fed would be able to sell the assets when necessary, which would mitigate inflation risk.

Despite these concerns, of the three options Bernanke described, he seemed most positive about this one.

2. Announce that short-term interest rates are going to stay really low for a really long time.

The Fed is already telling the world that short-term interest rates are going to stay super low "for an extended period." But it could go further, and tell the public that it plans to keep rates low "for a longer period than is currently priced in markets," Bernanke said.

The Fed could do this by promising to keep rates super low until a certain date — provided that certain economic conditions did not change. Central banks in Canada and Japan have used this technique in the past.

But Bernanke seems a bit wary of this option, which would have to come with lots of caveats and might be hard to articulate. "[I]t may be difficult to convey the Committee's policy intentions with sufficient precision and conditionality," he said.

3. Lower the Fed's interest rate for banks.

When banks store their money with the Fed, the Fed pays them a little bit of interest. The current rate is 0.25 percent.

The Fed could lower the rate to zero, Bernanke said. That would theoretically discourage banks from parking their money with the Fed, and encourage them to lend it out instead.

But because other short-term rates are already very close to zero, lowering the interest rate that the Fed pays banks would have only a small effect on the broader economy.

What's more, he said, lowering the rate to zero could disrupt key short-term finance markets that the Fed needs for its normal operations.

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