"Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver -- the provision of liquidity -- remains effective," Bernanke said in a speech Monday in Texas. "The Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand."
Fed deploying unconventional tools
Bernanke's comments are the Fed's latest hint that the world's most powerful central bank will deploy a 'new tool box' and unconventional techniques that Bernanke has previously said most likely would be needed to help the nation cope with its most serious financial crisis since the Great Depression.
Moreover, although the potential actions announced Monday technically are not quantitative easing, they will have that effect, says economist David H. Wang. Quantitative easing involves increasing the reserves in the banking system after the Fed loses the ability to lower the cost of money from an interest rate standpoint.
"Just call the proposed action 'modified quantitative easing,' where the Fed buys bonds from a selected agency or agencies," Wang said. "The effect will be the same -- interest rates will drop, creating demand, and there will be more money in supply. The U.S. economy needs both."
And, as both Bernanke and Wang noted, a Fed statement of intended action last week had that effect. After the Fed announced a plan to purchase up to $100 billion in Government Service Enterprise (GSE) debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters, mortgage rates at the retail level -- what people pay more mortgages -- fell.
Monetary Policy Analysis: Bernanke added that the Fed may also expand its efforts supply liquidity directly to the markets, and bypass banks and institutions.The Fed's goal is to free up credit in much the same way it has freed up credit in financial institutions via its term auction facilities. The danger is that the Fed adds too much money into the system, and inflation increases. However, as Bernanke noted, that danger is distant and the front-and-center concern remains financial system and economic stabilization, including the loosening up of credit conditions to facilitate the business and consumer demand that's essential for economic growth.