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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.

By Ezra Klein  |  August 17, 2010; 4:42 PM ET
Categories:  Federal Reserve  
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Both this article and the Fed's models are dangerous nonsense. If the Fed's model's worked, they would not have had to resort to their extreme current policies in the first place. People don't make decisions based on what the Fed does. Right now the economy is living generally with excess capacity, with the recent experience of the consequences of bad investment decisions, with stock and real estate prices that are still high by historical standards, and with the price of gasoline already around 80 dollars a barrel. If the Fed pumps enough money in and pushes investors to take ever more risk, possibly they could push the economy across a threshold that triggered some kind of unsustainable boom like the one that happened with Real Estate prices in the last cycle. Once the boom gets started, the Fed has no chance to control it. All the money that triggered it just starts moving faster. More and more bad investments are made driven by the feedback of some apparently rapidly rising asset value. The Fed's only realistic option is to try to slowly raise interest rates and induce some kind of soft landing. But of course, the reality is the same on the down side because the Fed has no effective ability for any kind of precise control over the economy. We saw it all happen from 2003 to 2008. It is hard to understand the level of denial that keeps someone like Ezra from getting it.

Posted by: dnjake | August 17, 2010 6:43 PM | Report abuse

Gagnon's prescription for Fed action and the case made by Chris Hayes in an earlier post are solid economic arguments, yet they only address part of the problem.

Much has been written about corporate unwillingness to make investments, but much has also been written about the need for increased demand. The larger issue is about both supply and demand (or corporate investment and consumer spending). In our current economic situation supply may not be enough to drive demand.

Fed action may be warranted, but the case still exists for measures to stimulate demand.

Posted by: MassachusettsLiberalinDC | August 17, 2010 6:58 PM | Report abuse

Read this interesting story about how the current economic climate is affecting a PR firm in exurban Chicago. Grim stuff:

Posted by: HitEleven | August 18, 2010 3:58 AM | Report abuse

It's hard to accept that we're not as rich as we thought we were, inflation could be the cure (money illusion allusion). So...let the Fed go nuts- just don't hold any dollars while they're doing it.

On the other hand, it's sad to see that so many macro economists look at this with such a national bent. Companies don't have to borrow in the US to expand. I have a credit facility from what is essentially a Canadian bank. When the second largest economy (and one of the largest creditors of the US) in the world has their currency pegged to the dollar, the normal benefits of devaluation don't apply.

To MassachusettsLiberalinDC- read the previous interview with Dean Baker about demand. We don't need to recreate bubbly demand, this is the new baseline and we must adjust to satisfying demand outside of the US, which means getting wages * productivity in line with the rest of the world.

Posted by: staticvars | August 18, 2010 9:53 AM | Report abuse

Oh. My. God.

While I'm right with dnjlake in calling Gagnon's suggestions "dangerous nonsense," it's not for the same reasons.

It's because what he called the "4-year treasury note" is a non-existent Fed instrument. There is no such thing. And this guy is former associate director of monetary affairs at the Federal Reserve?

I'm being polite when I say he's not living in the real world.

Posted by: Rick00 | August 18, 2010 1:57 PM | Report abuse

Sorry, I meant "Treasury instrument." The Fed has no instruments, natch.

Posted by: Rick00 | August 18, 2010 2:23 PM | Report abuse

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