The U.S. Federal Reserve is considering a new approach to unconventional monetary policy that would give it more leeway to tailor the scale of its stimulus to changing economic winds.
While fresh measures are not assured and the timing of any potential moves are still in question, some officials have said any new bond buying, or quantitative easing, could be open-ended, meaning it would not be bound by a fixed amount or time frame.
"I am inclined to think that if the Fed decides on more QE it would be of the open-ended variety," said Michael Feroli, chief U.S. economist at JPMorgan and a former Fed economist.
Because it would have no set limit other than the supply of Treasury or mortgage securities available, this method could eventually lead to very aggressive action, particularly if it is tied to an economic target - such as bringing the nation's 8.3 percent jobless rate down beneath, say, 7 percent.
But Feroli believes the Fed, still smarting from Republican criticism of its $600 billion bond-buying spree last year, probably wants to start small.
"A more plausible outcome would actually be more cautious than past shock-and-awe QEs: most likely they commit to just doing more QE until the next meeting or two, and then re-assess after that without specifying stopping conditions," he said.
After spending $2.3 trillion on two rounds of bond purchases, the Fed suggested in minutes of its August meeting last week that more stimulus would be in the offing unless the economy perked up quickly.
Open-ended bond buying could help officials avoid the sticker shock of a large upfront commitment, potentially winning over some reluctant inflation hawks on the policy committee and shielding the Fed from political pushback ahead of the November 6 presidential election.
Economists said it would give the Fed a more nimble method of influencing the economy, but it could also add new intensity to the institution's sometimes-controversial approach of keeping long-term interest rates down through large-scale bond buying.
"The economy doesn't listen to fixed time dates, it has its own ebb and flow," said Michael Gapen, senior U.S. economist at Barclays Capital in New York.
St. Louis Federal Reserve Bank President James Bullard has long backed the idea of using the central bank's balance sheet as a meeting-to-meeting tool in the same way interest rates worked before officials brought them down to zero in late 2008.
"Markets have this idea that, there's QE1 and QE2, so QE3 must be the same as those previous ones. It's not that clear to me that this is the way this is going," Bullard told CNBC on Thursday, explaining how his preferred approach might work.
"It would just be to do balance sheet policy as the exact analogue of interest rate policy," he said.
The possibility appears more likely after the minutes showed officials yearning for greater wiggle room.
"Many participants indicated that any new purchase program should be sufficiently flexible to allow adjustments, as needed, in response to economic developments or to changes in the committee's assessment of the efficacy and costs of the program," the minutes released on Wednesday said.
That reference raised the odds of an open-ended program to 60 percent, higher than the chances of the Fed doing traditional quantitative easing, said Anthony Chan, chief economist at Chase Wealth Management in New York.
An unlimited sum would eliminate the tricky question of how much the Fed should spend. If the central bank overshoots, it unnecessarily inflates its balance sheet, but if the amount of purchases is too small, it runs the risk of not achieving its goal of improving the economy.
"They get the best of all possible worlds," said Chan. "By keeping it open-ended, you can't by definition disappoint the market."
Others see it a bit differently. James Marple, economist at TD Securities, thinks a constant reassessment on the Fed's part could heighten volatility in the bond market, thereby lessening the beneficial effects of the Fed's efforts to keep rates down.
OLIVE BRANCH OR ATTACK OF THE DOVES?
Atlanta Fed President Dennis Lockhart, who is seen as a bellwether policy centrist, told reporters on Tuesday an open-ended stimulus is among the options being considered, though he added that he had not made up his mind about whether the likely benefits of more monetary support outweigh the potential costs.
Other officials like John Williams, Charles Evans and Eric Rosengren, the dovish presidents of, respectively, the San Francisco, Chicago and Boston regional Fed banks, have also voiced their support for such an approach. Fed Vice Chair Janet Yellen would likely also be open to the idea.
The August minutes set a low bar for the Fed to act. Many policymakers were inclined to take new easing measures "fairly soon" barring "substantial and sustained" improvement in the economic backdrop, they said. Still, a raft of better economic data since the meeting have prompted some analysts to pare back the chances of further Fed stimulus.
The fluidity of an open-ended approach could prove particularly attractive as European leaders scramble to find the right policy response to resolve their region's debt problems.
"If somehow the European Central Bank is more aggressive, then I don't think it really takes a rocket scientist to figure out that means the Federal Reserve has to be less aggressive," said Chan.
Nonetheless, open-ended QE would be a fairly radical move, said Steve Wyatt, a professor of finance at Miami University's Farmer School of Business. It would be akin to setting explicit targets for bond yields, or even setting a target for the level of prices that forces policymakers to make up for deviations from their policy goal.
That means the central bank could effectively be willing to tolerate a little bit higher inflation to jolt economic activity enough to bring down unemployment, something Fed Chairman Ben Bernanke has repeatedly ruled out.
The Fed's only previous experience with such a policy of rate-targeting, in the aftermath of World War II, suggests it can be done. An academic study of the post-war period conducted in the 1990s, however, finds the policy was employed for a different purpose - to stabilize what had been highly volatile interest rates rather than to jumpstart a persistently weak recovery.
Bernanke, when he was a central bank board governor in 2003, gave a now famous speech on the threat of deflation called "Making sure it doesn't happen here" in which he backed yield-targeting as a deflation-fighting tool.
"A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt," he said.
For now, deflation does not appear to be a threat, though inflation is sufficiently subdued to give central bankers comfort as they consider more stimulus to lower unemployment.
A speech by Bernanke this coming Friday at the Fed's annual gathering in Jackson Hole, Wyoming, could offer some hints on whether Bernanke will want to test his own theory.
