To Ease or Not to Ease

Investors parse federal reserve meeting notes the way believers in Kabbalah parse ancient texts. If Ben Bernanke says might rather than may regarding a particular policy action, markets react. The import of his words, perceived and real, has grown in tandem with political dysfunction in Washington, since Bernanke–along with his Continental counterpart Mario Draghi, head of the European Central Bank–are the last men standing between the West and economic stagnation. Politicians can’t or won’t act to stimulate the economy. Only central bankers can save us.

But can they really? Does the Fed actually have any more useful tools in its kit to spur U.S. economic growth, which was a truly lethargic 1.5% in this past quarter? The answer is yes, but the tools aren’t the ones that were talked about at the most recent Fed meeting. Bernanke indicated then that the bank was willing to continue pushing interest rates down into 2014 but fell short of announcing another round of quantitative easing, in which the Fed buys large sums of Treasury bills from banks in an effort to increase the money supply, boost bank lending and jolt the economy into action.

Bernanke’s stutter step is good, because the past couple of rounds of Fed bond buying have been much less effective than the first. Once markets adjusted to the shock and awe of the first round, they started pricing in the effects. In all cases, much of the benefit went to the wealthy, anyway; stocks got a jolt, especially the first time around. But the mortgage market was less affected, and that’s what matters for a middle class whose wealth is still tied up in housing.

This speaks to the conundrum facing the Fed. In the absence of real fiscal stimulus by government, central bankers are left to try to stimulate the economy on their own. But their traditional tools for doing so–low rates and bond buying–are either no longer effective or not applicable to today’s problems. (In the U.S., quantitative easing was developed to deal with economic problems at home, not the headwinds currently emanating from Europe.) In order to keep things afloat until politicians get their act together, the Fed needs new strategies. They exist but come with risks. Bernanke and Co. could, for example, decide to stop paying the small amount of interest it pays to banks that park cash with the Fed, thereby pushing those funds into interest-yielding money-market accounts. But there are already well-founded worries that money-market funds are susceptible to bank runs–and unlike commercial accounts, they aren’t federally insured. That’s a $2.6 trillion disaster waiting to happen.

A more useful approach would be to target the mortgage market directly, since boosting the housing market would boost the economy at large. New-home construction is a jobs generator, and we sure could use them.

The problem is that while the Fed has pushed interest rates to record lows, it can’t force banks to lend that cheap money. “Everyone who can refinance their home already has,” says Paul Dales, senior U.S. economist for Capital Economics. “But there’s evidence that a lot of people still want to and simply can’t get financing.” Data show that demand for prime mortgages rose strongly in the second quarter of 2012, but lending standards were tightened, creating a bottleneck. Banks are reluctant to lend not only because of credit risk but also because they worry about the global economy and are unsure of everything from what tax rates will be to how Congress will handle the fiscal cliff.

The Fed can avoid gridlock. It can (and very likely will) buy mortgage-backed securities, but that doesn’t address the fundamental lending question. That’s why some economists are pushing for the U.S. to institute a funding-for-lending scheme along the lines of what’s being done in the U.K. Banks would be able to borrow money from the Fed and make a small profit on it but only if they lent that money to consumers. Such a plan would be outside traditional Fed policy, but as Mohamed El-Erian, CEO of Pimco, the world’s largest bond trader, puts it, “More of the same isn’t going to work. The Fed has to do something different.”

These loans would of course boost the Fed’s balance sheet and thus open it to new charges that it’s stoking inflation. But frankly, the inflation argument holds less and less water. With the savings rate up nearly a point in the past year and unemployment still above 8%, the megaworry isn’t 1970s-style inflation but a lost decade la Japan. Indeed, Fed rune readers are parsing hints that Bernanke may finally be willing to stop fighting the last war and let inflation rise a bit in order to stoke growth. That would be a welcome sign.

TO READ MORE BY RANA FOROOHAR, GO TO time.com/foroohar