Federal Reserve officials are considering a novel approach to bond buying aimed at countering some of the worry that another round of asset purchases by the central bank could fuel inflation, according to the Wall Street Journal.
Citing people familiar with the matter, the newspaper reported on Wednesday that should the Fed decide to buy more bonds to boost growth, it could borrow back the money it used to buy those bonds for short periods of time at low interest rates. Doing so would take that money out of circulation, or sterilize it.
Representatives from the Federal Reserve and the New York Federal Reserve Bank, which conducts the central bank's bond trading, declined to comment on the report.
The Fed is holding a regular policy meeting next week but is not expected to launch another round of bond buying at that time. It cut benchmark interest rates to near zero in December 2008 and has bought $2.3 trillion in bonds to push down short- and long-term interest rates low to stimulate growth.
However, Chairman Ben Bernanke has signaled that he would consider another round of bond buying to support the fragile recovery if tepid growth and modest improvements in the labor market falter. Many analysts believe the Fed will resort to a renewal of such measures, known as quantitative easing, later this year as higher oil prices and Europe's economic problems weigh on the United States.
Fed officials are considering different options should they decide to embark on another round of asset purchases, the report said.
Among these is an approach in which they would buy bonds, but restrict how investors and banks could use that money.
The Fed has tested tools to take money out of the financial system such as reverse repurchase , or repo, agreements to prepare for the day when the central bank wants to begin to tighten financial conditions.
Other bond buying options are avenues the Fed has already pursued, according to the article.
These are outright purchases of new Treasury or mortgage-backed securities , known as quantitative easing (QE) ; or selling shorter-term Treasury securities and replacing them with longer-dated Treasuries, a strategy that is already in place and known as Operation Twist.
This reverse repo (plan), or Operation Twist, it creates increased profits for U.S. government-securities dealers and the only stimulus you get from that is increased bar and restaurant sales in lower Manhattan, said Paul Kasriel, chief economist at Northern Trust.
Now if you're talking about pure QE, unsterilized quantitative easing, now that can have a stimulative effect on the economy, he said.
The U.S. stock market gained ground on the report, which suggested the Fed is actively considering how to be more aggressive in spurring growth. Financial markets had been disappointed that Fed Chairman Ben Bernanke did not mention prospects for further bond buying in congressional testimony last week.
With a recent rise in oil and gasoline prices posing risks to the recovery, the Fed could be looking for a way to boost growth without triggering inflation. The Fed's second round of quantitative easing in November 2010 is viewed by some as having contributed to rising global commodity prices at the time.
This operation could lower long-term rates and mortgage rates, without the negative side effects of boosting commodity prices, said Richard Gilhooly, director of interest rate strategies at TD Securities in New York.
Peter Boockvar, an equity strategist at Miller Tabak in New York, said: The mad scientists at the Fed are contemplating every single possible scenario to keep longer-term interest rates from moving higher.
The Fed has tested both reverse repurchase agreements and a term deposit facility to ensure that when it needs to drain excess bank reserves from the financial system, it can do so. The Fed's $2.9 trillion balance sheet is more than three times the size it was before the financial crisis, and the central bank must be careful to prevent excess bank reserves from sloshing around in the financial system and causing inflation when economic growth accelerates.
In reverse repurchase agreements, the Fed sells short-term Treasury securities on its books for a short period of time with an agreement to buy them back. The term deposit facility works like bank certificates of deposit, which allow an investor to obtain an attractive rate of return in exchange for locking up funds for a specified period of time.
Analysts said sterilizing funds to enable more bond buying might have an adverse impact on shorter-term interest rates.
Higher financing rates would push up 2-year and 3-year yields, said Michael Cloherty, head of U.S. interest rates strategy at RBC Capital Markets in New York.
(Reporting By Mark Felsenthal, additional reporting by Richard Leong and Jonathan Spicer in New York; Editing by Chizu Nomiyama and Diane Craft)