This is the second part of a two-part op-ed published in the Fiscal Times. The first part attests to the effectiveness of monetary policy in providing stimulus to the economy.
Last week I discussed how monetary policy has softened the economic slump that resulted from the financial crisis and the underlying structural problems in the economy. Going forward, the key question is whether it would be helpful and possible for the Fed to do more. I say “yes” on both counts.
It is not hard to find reasons for more monetary stimulus. The recovery has been lackluster, and recent data on spending and hiring suggest there has been a meaningful loss of economic momentum from earlier this year. Although inflation hawks worry about the extensive monetary policy actions to date, I agree with my former Fed colleague, Joe Gagnon, who has been arguing for months now that the risks of deflation are greater than those of inflation.
The Fed still has many feasible options. Among them are lowering the interest it pays on banks’ excess reserves and changing its communications to signal a yet-greater commitment to keeping the short-term Fed policy rate low for a very long time. But the option I find most compelling is to purchase more long-term assets. Evidence suggests that the Fed’s commitment to purchase $1.7 trillion in U.S. Treasury securities and GSE and FHA mortgage-related securities in 2009 and early 2010 lowered the private long-term interest rates that influence household and firm spending by a meaningful amount. Although those rates are now low by historical standards, they are generally still well above zero, implying that further purchases have the potential to reduce rates further and thereby spur aggregate demand.
What securities should the Fed buy if it expands its purchases? Although it sounds appealing to directly target portions of the private lending market where rates remain high, this is not possible. The current situation is not dire enough to easily justify such action under the “unusual and exigent circumstances” clause of the Federal Reserve Act, and legal restrictions otherwise preclude purchases of securities not issued by the government or government agencies. Those restrictions are for the best—were the Fed to target specific industries or groups of people, it would inevitably face greater political pressures, the dangers of which Mark Thoma warned us about last week.
As for GSE and FHA mortgage-related securities, the earlier purchases made sense given the extreme fragility of the housing market. However, they also essentially financed the vast majority of new mortgages in this country over the past year and a half. Continued government dominance in this area could thwart the comeback of the private mortgage market—an important ingredient for a self-sustaining recovery.
The best option then is for the Fed to purchase more longer-dated U.S. Treasury debt, though even this strategy is not without complications that could end up counteracting the intended drop in private interest rates. Fed policy decisions provide news not only about future Fed actions, but also about where the Fed thinks the economy stands at the moment. One communications challenge would be making sure that an announcement of significant new purchases did not create the perception that the Fed believes the economy is even more precarious than it appears. If risk premiums were to rise with such an announcement, the downward pull on private interest rates from lower Treasury rates might be undone.
Simultaneously, the Fed would have to be clear that these new purchases were, like their earlier actions, motivated solely by the need to bolster the weak economy over the near term. Were investors to believe that the purchases were part of a long-term interest in monetizing the federal debt, new inflation fears could boost nominal Treasury rates, with the result being that these rates do not fall as much, or even rise.
Though Chairman Ben Bernanke is planning a speech at the Fed’s annual economic symposium in Wyoming on Friday, we are still several weeks away from the Fed’s next scheduled policy-setting meeting. In the meantime, Fed leaders face the challenge of distilling incoming information to gauge how weak the economy is. One thing that is not a challenge, however, is a lack of options for further monetary stimulus.