What the Federal Reserve could -- but probably won't -- do
Joseph Gagnon, a former associate director of monetary affairs at the Federal Reserve lays out exactly what he thinks the Federal Reserve should do to help the economy, and exactly how much he thinks those actions will do to help the economy.
First, the Fed should lower the interest rate it pays on bank reserves to zero. This is a small step, as the current rate is only 0.25%, but there is no reason to pay banks more than the rate paid by the closest substitute, short-term Treasury bills. Three-month Treasury bills currently yield 0.15%, and that rate, too, should be brought down to zero.
Second, the Fed should bring down the rates on longer-term Treasury securities by targeting the interest rate on 4-year Treasury notes at 0.25% and aggressively purchasing such securities whenever their yield exceeds the target. That is a 75-basis point reduction from the current rate of 1%. This step would also push down longer-term yields and reduce a wide range of private borrowing rates, encouraging business investment, supporting the housing market, and boosting exports through a weaker dollar. Moreover, pushing down yields on short- to medium-term Treasury securities is precisely the strategy for fighting deflation recommended by Ben Bernanke in 2002
Finally, the Fed could bolster the stimulative effects of these actions by establishing a full-allotment lending facility to enable banks to borrow (with high-quality collateral) at terms of up to 24 months at a fixed interest rate of 0.25%.
These measures are all within the Federal Reserve’s established powers. They pose essentially no risk to the Fed’s balance sheet. Roughly speaking, they comprise a net easing of the stance of monetary policy equivalent to a 100 basis point cut in the federal funds rate. According to the Federal Reserve’s own economic model, such a policy move would reduce unemployment roughly as much as a 2-year $500 billion fiscal package and yet it would actually reduce the federal budget deficit. And it can be reversed quickly should the balance of risks shift from deflation to inflation.
August 17, 2010; 4:42 PM ET
Categories: Federal Reserve
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