"Monetary Policy Can Do More"

Joseph Gagnon has been frustrated with those of us who have not fully embraced further action by the Fed to lower long-term interest rates. Here's his description of some new research on this issue:

Monetary Policy Can Do More, by Joseph Gagnon, Peterson Institute for International Economics: A new study in which I participated has been posted on the website of the Federal Reserve Bank of New York. It documents how the Federal Reserve lowered long-term interest rates about 50 to 60 basis points last year through its purchases of $1.7 trillion of longer-term bonds. The study reinforces an argument I have previously made: that the Federal Reserve and other central banks can apply further monetary stimulus by lowering long-term borrowing costs even when short-term interest rates are stuck at zero. (For the wonkish, the effect appears to work though the term premium rather than through expectations of future short-term interest rates.)

The reduction in long-term interest rates applies not only to Treasury securities, but also to mortgages and corporate bonds. Households buying and refinancing their homes took out mortgages worth over $2 trillion in 2009 and they will save about $11 billion in interest payments each year because of the lower interest rates. With interest rates remaining low for new borrowers in 2010, these benefits will continue to grow and will help to support consumer spending and economic recovery. Thanks to the low interest rate environment, corporate bond issuance (net of redemptions) reached a record $381 billion in 2009, helping to finance a turnaround in capital spending late last year that exceeded most private forecasts.

With unemployment projected to remain far above most estimates of its equilibrium for the next few years and with core inflation having fallen to 1 percent over the past 6 months, the US economy clearly needs more of this medicine. As I argued last December, the Fed could push down long-term yields another 75 basis points by buying a further $2 trillion of long-term bonds. Current yields on 10-year Treasury notes, at 3.7 percent, are far above the zero rates on short-term Treasury bills. The benefits to the economy would be rapid and similar to those already observed from the first round of Fed purchases. Moreover, lower long-term interest rates and a faster recovery would also reduce our national debt.

Does additional Fed action mean that inflation is going to come roaring back? Not unless the Fed forgets everything it learned from the 1970s. But right now, inflation is below the Fed’s target of 2 percent and heading lower. The immediate problem is deflation. As Japan shows, acting too weakly against deflation is a serious error. Yes, the Fed may have to reverse course in a couple years, but that would be better than facing a decade of excess unemployment and entrenched deflation.

I have been working on a write-up of how the crisis will affect monetary and fiscal policy in the future based upon my discussion at the Kaufman Center's recent Economic Bloggers' Forum. Here's the draft version of what I wrote on this issue:

Quantitative Easing: Whether or not the Fed embraces more aggressive quantitative easing the next time a crisis hits depends critically upon how gracefully the Fed can exit from the policies implemented during this crisis. If, as I believe, the Fed can exit without an outbreak of inflation, then one conclusion that will most likely be drawn is that the Fed was way too timid with its quantitative easing policy. However, if inflation does turn out to be a problem, it will call the whole policy procedure used during the crisis into question.

I was among the people who (probably) had too much fear of inflation and hence was unwilling to fully embrace more aggressive policy (though I did give lukewarm support). The Fed's credibility is shaky, and I was worried that if there was an inflation problem, it would further undermine the Fed's credibility and cause Congress to take more control over monetary policy, something I thing would be a big mistake and lead to worse policy outcomes in future recessions. I was also skeptical that a fall in long-term real interest rates would induce much in the way of new investment and the consumption of durables due to poor economic conditions, so the benefits of the policy seemed small relative to the potential costs. As I said above, right now I don't expect inflation to be a problem, but the Fed's exit is just beginning, so we will have to wait and see.