Fed Has Some Tricks Left, but None Are Magic

Since the onset of the financial crisis in August 2007, Federal Reserve Chairman Ben Bernanke has been pulling rabbits out of his hat. He cut interest rates to near zero, printed $2.3 trillion to buy Treasury bonds and mortgage debt, and, with a posse of sleepless economists, devised an alphabet soup of rescue programs for commercial-paper markets, money-market funds, dollar-starved European banks and other strained players in the vast global financial system.

The objective: to keep the damaged postbubble economy from drifting into zombie-land. Now, stock markets are gyrating and the economic outlook is growing dimmer. S&P's downgrade of U.S. debt is a reminder that the financial system is one shock away from more instability. As Mr. Bernanke prepares to lead a meeting of the Fed's policy committee Tuesday, he must be asking himself: Are there any rabbits left?

The answer: Yes. But some of them are very small. Some might bite. And he's reluctant to pull them out until he is sure the audience is ready.

In January, the Fed projected U.S. economic output would grow by as much as 3.9% this year. In April, it revised that down to 3.3%, in June, 2.9%, and now that looks optimistic. Unemployment is stuck above 9%. Prices rose more than the Fed expected early in the year, though inflation shows signs of retreating.

If Mr. Bernanke can help the economy, even at the margins, his record shows he will try. But he also is determined not to stir up inflation—now running nearer to the Fed's 2% objective—more than he already has.

Worries about causing inflation fears, coupled with divisions inside the Fed, make it unlikely that Mr. Bernanke is about to unleash a torrent of new securities purchases, known as quantitative easing. That's the big rabbit that might bite.

The earlier round of purchases was meant to hold down long-term interest rates and spur investment and spending, but printing lots of dollars puts upward pressure on prices and downward pressure on the foreign-exchange value of the dollar. While QE2, as it has been dubbed, has its critics, Mr. Bernanke is a believer. But he was more willing to try it last year, when inflation was too low, than he is now. As Donald Kohn, Mr. Bernanke's former top lieutenant, said last week, the Fed would probably want to wait to be sure inflation is actually slowing before launching QE3.

The smaller rabbits include the following. The problem is that none would do much to get the economy moving faster.