On June 20, 2012, the Federal Reserve System’s Federal Open Market Committee extinguished the last shred of doubt as to whether it intends to achieve its mandated objectives. Despite a substantial markdown of an already inadequate forecast, the Fed did not take any actions that would make it possible to achieve either of its objectives over the foreseeable future. The action that was announced—additional purchases of longer-term Treasuries worth $267 billion—is estimated to reduce the 10-year Treasury yield by no more than 5 to 10 basis points. That is an amount that is lost in the daily fluctuations of the Treasury market and not enough, even in the Fed’s own models, to have an appreciable effect on the economy.
For more than two years, the Fed has dragged its feet and resisted the obvious need for more aggressive action. At this point it is not clear that the Fed has the tools it needs to get the best possible outcome without help from fiscal policy. Nevertheless, the Fed has considerable firepower remaining. It should aggressively push down mortgage interest rates and state clearly that it would welcome an inflation rate temporarily above its 2 percent target in order to make faster progress on its employment objective. These measures, discussed below, would substantially improve the economic outlook, even if there is disagreement about whether they are sufficient by themselves.
Why No Action?
A number of well-known Fed watchers have wrung their hands in despair at this policy paralysis. What lies behind the Fed’s inaction?
- Many observers believe that the Fed has done all it can to help the economy. Yet Chairman Ben S. Bernanke asserted in his press conference last week that the Fed has not run out of ammunition. And his previous academic research strongly supports that view.
- Harvard professor Martin Feldstein, former chairman of the Council of Economic Advisers, argues that the sluggish recovery proves that monetary policy has lost its potency. He has succumbed to the fallacy of the driver who wonders why pressing on the accelerator does not cause the car to speed up as it starts to climb a hill. Feldstein also worries that further Fed action might cause foreigners to lose confidence in the dollar and spark a jump in bond yields. But the Fed has an unlimited capacity to make up any shortfall in bond demand. And Feldstein ignores the direct stimulus that the resulting dollar depreciation would provide to US exports.
- Tim Duy, in his Fed Watch blog, wonders if the uncertainty over the effect of unconventional monetary actions has caused the Fed to be so timid. One thing is certain: Unconventional actions taken to date have not been sufficient to achieve the Fed’s mandate. Surely the lesson must be to take larger steps, not smaller ones.
- Ryan Avent, of the Economist, suggests that concern about unspecified “costs and risks” is the most likely reason the Fed is not taking more aggressive actions, and the Chairman’s remarks at last week’s press conference seem to support this view. I discuss potential risks of further action below, but none seem anywhere near as costly as the well-known cost of continued high unemployment.
- Paul Krugman guesses that the Fed is intimidated by Congressional Republicans. Indeed, it is remarkable that despite falling short of both of its objectives, neither the Administration nor Congressional Democrats have criticized the Fed for doing too little, whereas Congressional Republicans have denounced the Fed for doing too much. Countering these claims, Chairman Bernanke told reporters last week that political considerations have no effect on the Fed’s decisions, and Congressional action that would harm the Fed or individual Fed officials seems unlikely.
- Some have described the Fed’s action last week as one of saving ammunition to deal with a future crisis, such as a collapse in Europe. But this explanation assumes that the Fed believes it is running low on ammunition—which the Chairman has denied—and it goes against the Fed’s prevailing philosophy of proactively boosting the economy when major risks are tilted to the down side.
The Risks of Action
After his dissenting vote last week, the president of the Federal Reserve Bank of Richmond, Jeffrey Lacker, stated: “I do not believe that further monetary stimulus would make a substantial difference for economic growth and employment without increasing inflation by more than would be desirable.” The view that unconventional monetary policy will lead to inflation is commonly held on Wall Street. Yet, more than three years after the launch of such policies, inflation remains at or below the Fed’s target. Moreover, past statements by Chairman Bernanke, Vice Chairman Janet Yellen, and other members of the Fed’s policy committee indicate that they do not share President Lacker’s view that monetary stimulus can increase inflation without also increasing growth and employment. A large majority of the committee projects that inflation will be below target over the next two and a half years. If they assign any weight to their employment objective, they should be willing to accept inflation at least modestly above target in order to get a better outcome on employment.
Purchasing more long-term assets at low interest rates raises the risk that the Fed will incur losses in the future. That might give the Fed some political discomfort. But maximizing profit is not part of the Fed’s mandate. Moreover, any losses on the Fed’s balance sheet would be more than offset by gains to the Treasury’s balance sheet.
In his press conference, Chairman Bernanke listed the potential risks of unconventional monetary policies as those related to market functioning, financial stability, and the exit process. Considering the staggeringly high cost of record long-term unemployment, these risks would have to be serious indeed to justify the lack of policy action. Yet, the Fed has provided no evidence that these risks should be taken seriously.
- The risk to market functioning arises from the large role the Fed plays in some markets when increasing or decreasing its balance sheet. During the first and largest bout of quantitative easing in 2009, the Fed at times was buying almost all newly issued agency mortgage-backed securities (MBS). Other buyers were displaced from the market, which was in fact one of the goals of the policy. However, when the Fed ceased buying in March 2010, other participants returned quickly and there was no harmful disruption.
- The risk to financial stability is that unconventional policies may make asset price bubbles more likely. So far, however, asset prices remain depressed and raising them is much to be desired. If a bubble were to grow in the future, the Fed should use its regulatory and supervisory tools to counter it. But for now the greater risk to financial stability arises from allowing the economy to continue to perform badly, which increases the pace of bankruptcies and nonperforming loans.
- The risk to the exit process is a variant of Wall Street’s concern about inflation, which is merely postponed into the indefinite future. However, the Chairman has repeatedly told Congress that the Fed has the tools it needs to achieve its mandate now and in the future. Assets that were bought can be sold or lent in the repo market, and the Fed now has the enormously powerful tool of setting the interest rate on excess bank reserves. At its root, this risk is simply that the Fed will make a mistake in the future. Given the unusual circumstances we face now and over the next few years, it is reasonable to worry that the Fed may not choose the best policy. But it is not obvious whether a future Fed mistake would lead to too little or too much inflation. Moreover, fear of a future policy mistake is not an excuse to make a current policy mistake.
What Is to Be Done?
The best option within the Fed’s legal authority is to announce a target range for the 30-year mortgage rate of 2.5 to 3 percent to be maintained for the next 12 months. This target would be enforced through unlimited purchases of MBS guaranteed by the federal housing agencies. The 12-month commitment would encourage banks to beef up their mortgage staffing and it would give potential homebuyers some assurance of the financing they could expect while they shop for a house. This is similar to a program I outlined last fall. The Administration could help by forcing the housing agencies to stop dragging their feet on refinancing and loan modifications for underwater borrowers whose mortgages are already guaranteed by the agencies.
Although not a panacea, the above measures are substantial and would be viewed as such by market participants. The Fed could enhance their effects by stating clearly that a little more inflation would be welcome. A temporary increase of inflation to as much as 4 percent would be justified to the extent that it enabled a faster return to full employment. Raising expectations of future inflation moderately—in conjunction with a continued commitment to a near-zero policy rate—would lower the real interest rate, providing additional impetus to economic activity.
Running Low on Ammunition?
If necessary, the above program could be extended in time at a slightly lower interest rate. But the Fed is unlikely to be able to push the 30-year mortgage rate below 2 percent, or the 10-year Treasury rate much below 1 percent.
The main alternative instrument in the Fed’s toolkit is foreign exchange, generally in the form of sovereign bonds of foreign governments.1 The point of such purchases would be to drive the dollar down and boost US exports. Massive purchases of such bonds would be considered an act of economic warfare by many recipient governments, despite the hypocrisy implied by the large purchases of US bonds by many of the same foreign governments.
A foreign-exchange program that would not face opposition from abroad would be large-scale purchases of Italian and Spanish bonds. That would defuse the euro debt crisis at a stroke, thereby eliminating the main downside risk to the US economy. But such purchases would expose the Fed to even stronger domestic political attacks than it has already faced. Chairman Bernanke explicitly ruled out this option last week.
The best alternative would be to purchase exchange-traded funds of the total US stock market. That would have broad-based benefits, repairing household balance sheets and unlocking consumption and investment. Unfortunately, the Fed is not authorized to buy equities and Congress is not likely to grant it that power anytime soon.
1. The Fed is allowed to buy state and municipal bonds with maturities of less than 6 months. That represents a fairly small asset class, and one that already benefits from very low yields.