FOMC may need to set reserves target

The Federal Reserve, with little room to cut interest rates further, has shifted to a policy of intentionally flooding the banking system with reserves and should consider setting an explicit reserves target, a top Fed economist said. That, in turn, could force a change to the way the Fed relays its actions to the market, Glenn Rudebusch, the San Francisco Fed's associate director of research, said in the FedViews newsletter posted on Monday on the bank's website. "It may be that going forward the post-Federal Open Market Committee meeting statement may have to be recast to contain a discussion of reserve quantities," Rudebusch said. The Fed has slashed its benchmark federal funds rate to 1 percent from 5.25 percent since September 2007. Some Fed officials, most recently Philadelphia Fed President Charles
Plosser last week, have cited difficulties in cutting the overnight interbank
target lending rate further.

However, "it is not the case that the Fed is necessarily 'on hold.' Indeed, the Fed has already started to employ alternative means," Rudebusch said. Quantitative easing, a strategy of aggressively expanding the size of the Fed's balance sheet to boost the level of reserves in the banking system and induce banks to make more loans, was started in September, he said. Rudebusch said the FOMC, which traditionally has deliberated about monetary policy mostly in terms of interest rates, needs to rethink that strategy. "It may be appropriate to shift to a reserves quantity target in addition to or in place of the interest rate target, both in the policy discussion and in the operational directive" made to the New York Fed's trading desk, he said.

The jury is out on whether another tactic adopted by the Fed, altering
the composition of its balance sheet by selling Treasuries and buying private
debt such as commercial paper, is helping to boost the economy, Rudebusch said.
The Fed economist said a third key strategy at a time short-term rates
are pinned near zero would be for the Fed to project "a credible public
commitment to keep the funds rate low for a sustained period of time."
Rudebusch noted that the 10-year U.S. Treasury note yield is still
relatively high, near 3.67 percent. "When the Bank of Japan promised in 2001 to keep its policy rate near zero as long as consumer prices fell, it was able to help push the rate on 10-year government securities down below 1 percent," he said.
Some Fed policy-makers have taken the opposite approach, though,
stressing the need for the Fed to start raising rates once the economy turns up.

ECONOMY UNDER PRESSURE INTO MID-2009
Rudebusch forecast that the U.S. economy would bottom out in the fourth
quarter of 2008, with a decline in gross domestic product of more than 3
percent, followed by smaller declines in the first two quarters of 2009.
The U.S. jobless rate will likely peak at about 7.5 percent in mid-2009,
he said. A retrenchment in the outlook for global growth opens the door to far
lower inflation, he said. San Francisco Fed economists now see headline inflation falling from above 4 percent to below 1 percent by the middle of 2009. Core inflation, stripped of food and energy costs, could fall to about 1.5 percent by the end of 2009.