What can the Fed do?
What’s at stake: The spate of competing statements in recent weeks indicates that there is a bit of an intellectual battle taking place within the Fed as a result of the second quarter’s disappointing economic numbers. Several Fed officials emphasized the "we can do more" story in what be considered as a pre-emptive effort to […]
What’s at stake: The spate of competing statements in recent weeks indicates that there is a bit of an intellectual battle taking place within the Fed as a result of the second quarter’s disappointing economic numbers. Several Fed officials emphasized the "we can do more" story in what be considered as a pre-emptive effort to alleviate the seemingly hawkish stance of the last FOMC minutes. It remains, therefore, unclear whether the economic indicators deteriorated enough between the Fed’s June meeting and last week to inject new urgency into the hearts of the central bankers. Hopefully, Federal Reserve Chairman Ben Bernanke will provide additional clarity with regard to additional easing at next week’s semi-annual testimony.
Tim Duy points out that the FOMC minutes read as if additional policy stimulus is a remote chance. As has been reported, recent Fed-speak has been decidedly more mixed. Last week the Washington Post raised expectations that the Fed was seriously considering additional policy action as several Federal Reserve Bank officials acknowledged that the central bank still had tools at its disposal that it could use to spur a "faltering" economy recovery. If the Fed decides to take action, it remains to see which actions are more likely to be on the table and how effective they can be.
Calculated Risks writes that if the Fed decides to take action, the FOMC might announce "explicit ceilings for yields on longer-maturity Treasury debt" – just like they do with the Fed funds rate at each FOMC meeting. This was something Ben Bernanke argued for back in a 2002 speech. A direct method to bringing down longer-term rates, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years), Bernanke said. The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.
Neil Irwin writes that the Fed could expand the "extended period" language in the FOMC statement to describe an even longer period, or buy more agency MBS (mortgage backed securities). One pro-growth strategy would be to strengthen language in Fed policy statements that the central bank’s interest rate target is likely to remain "exceptionally low" for an "extended period." The policymakers could change that wording to effectively commit to keeping rates near zero for even longer than investors now expect, perhaps adding specifics about which economic conditions would lead them to raise rates. Another possibility would be to cut the interest rate paid to banks for extra money they keep on reserve at the Fed from 0.25 percent to zero. That would give banks slightly more incentive to lend money to customers rather than park it at the Fed, although it also could cause technical problems in the functioning of certain credit markets. A third modest possibility would be to buy enough new mortgage securities to replace those on the Fed balance sheet that are paid off as people take advantage of low interest rates to refinance.
Paul Krugman says that it’s good to see the Fed getting worried; but don’t get too excited. In a way, the problem with Bernanke’s speech was that he made increasing demand and fighting deflation sound too easy. The Fed can print money, if you increase the supply of something its price will fall, end of story. But this simple story breaks down when short-term interest rates are near zero. When the Fed conducts an open-market operation, buying short-term debt with newly printed money, this normally affects the short rate because bonds and money are imperfect substitutes: money yields less, but has the advantage of being something you can use directly to make payments, that is, it’s more liquid. But when you have bought so much debt and created so much money that rates are near zero, the public is saturated with liquidity; from that point on, they’re holding money simply as a store of value, which makes it no different from bonds — and hence a perfect substitute for bonds. And at that point further open-market operations do nothing — they just swap one zero-interest asset for another, with no effect on anything.
For several analysts, there’s only one way the Fed can affect things at all: by promising, credibly, more inflation in the future.
Ben Bernanke, Vincent Reinhart and Brian Sack argued in a 2004 paper that convincing the public that the Fed is committed to a higher inflation rate or price level for the foreseeable future is one of the big guns that could be used. An historical episode that may illustrate this channel at work (although the policymaker in question was the executive rather than the central bank) was the period following Franklin Roosevelt’s inauguration as U.S. president in 1933. During 1933 and 1934, the extreme deflation seen earlier in the decade suddenly reversed, stock prices jumped, and the economy grew rapidly. Unlike the policymakers who preceded him showing little inclination to resist deflation and, indeed, seeming to prefer deflation to even a small probability of future inflation, Roosevelt demonstrated clearly through his actions that he was committed to ending deflation and “reflating” the economy. Although the president could have simply announced his desire to raise prices, his adoption of policies that his predecessors would have considered reckless provided a powerful signal to the public that the economic situation had fundamentally changed.
Mathew Iglesias writes that Bernanke clearly understands the difference between what the Fed has been doing so far – i.e. “unorthodox” interventions into a variety of markets described as temporary efforts to forestall emergency in the financial system – and the regime change option that would induce promising a future higher price level. It’s not clear, however, why he’s not acting. It could be that he doesn’t think the situation warrants it. It could be that he doesn’t have enough support on the FOMC. It could be that he doesn’t think there’s enough political support to make such a policy tenable. But it’s possible that the confirmation of some new FOMC members combined with increased attention in the political media to this issue will spur some increased action.
Tim Duy argues that the Fed is dominated by bankers who believe that strong action is only merited when a total economic catastrophe is staring the nation in the face. Ben Bernanke is willing to enact extraordinary measures to avoid another Great Depression, but not to lower unemployment from 9.5 percent to 5.5 percent. Ryan Avent argues that there is no consensus among the Federal Board of Governors. The board seems split between those who are ready to start raising interest rates in the short term, and those who are worried that deflation and high unemployment are the most pressing dangers facing the economy. In this construct, Bernanke is a consensus builder, not a leader, and thus relatively powerless.
*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.
Republishing and referencing
Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.