With the economic recovery possibly faltering and little hope Congress will agree to further fiscal stimulus, some economists and politicians want the Federal Reserve to do more to spur growth and jobs. But don’t assume there’s much more the Fed can do at this point.
Federal Reserve chairman Ben S. Bernanke told Congress recently that there are some steps the Fed could take that would help, and that if the economy weakens the central bank will consider acting. He gave no details on what those steps might be.
The Fed has already cut its target for the overnight interest rate, traditionally its key tool for influencing the economy, almost to zero. Last year, research by economist Glenn D. Rudebusch at the San Francisco Federal Reserve Bank concluded that the recession was so severe that the only way the Fed could provide the economy with the same degree of support as it has in past slumps was to cut that target to a negative 5 percent. That's impossible, of course, since interest rates cannot fall below zero — the so-called zero bound for monetary policy.
Reducing Long-Term Rates
Joseph Gagnon, a former Fed economist now at the Peter G. Peterson Institute for International Economics, proposes that the Fed try to get around that limitation by reducing some longer-term rates nearly to zero as well.
"The three-year Treasury rate is 1 percent; the two-year rate is about three-fourths of a percent; so that's pretty low," Gagnon said recently in an interview posted by the Institute. "But nevertheless, lowering the three-year Treasury rate from 1 percent to one-fourth of a percent is a 75 basis point cut in the three-year rate," which could affect other rates as well. (The Institute is partly funded by Peter G. Peterson; The Fiscal Times is funded as an independent business by Peterson.)
"That's a fairly big policy step in the context of their normal actions," he said. "So, it's sort of, you know, maybe the right size that is needed right now."
However, as of yesterday the yield on 12-month Treasury securities was a scant 27 basis points (a basis point is one one-hundreth of a percentage point), with yields on two-year notes only 55 basis points and those on three-year notes 83 basis points. There's simply no reason to believe reducing all those to around 25 basis points — even if the Fed bought huge amounts of the securities in question to achieve such a target — would actually do much to help the economy. Compare the possible decline in those yields with Rudebusch's 500 basis point drop needed truly to stimulate the economy. "Given what has happened already, maybe you could squeeze this a little more, but how much are you going to get," said Ray Stone of Stone & McCarthy Research Associates. "I don't think you can get much mileage out of this."
Unfortunately, most of the other actions the economists want the Fed to take seem just as unlikely to do much to spur economic growth and job creation--or to ward off a debilitating period of deflation, another rising concern. At least one of the proposals, to stop paying interest on excess reserves held by banks, might force money market mutual funds to shut down and otherwise disrupt short-term money markets.
The Wall Street Journal reported Tuesday that Fed officials will consider a modest but symbolically important change in the management of their massive securities portfolio when they meet next week. At issue will be whether to use cash the Fed receives when its mortgage-bond holdings mature to buy new mortgage or Treasury bonds, instead of allowing its portfolio to shrink gradually, as it is expected to do in the months ahead.
Confronting Deflation
John Makin, an economist at the American Enterprise Institute, recently called on the Fed to "acknowledge the threat of deflation" and a slowing of economic growth "and pledge to keep the funds rate at zero for two years." Further, Makin said in a conference call with reporters, the Fed should set "a price level target" so that if inflation fell below a 1 percent to 2 percent range, it would allow inflation later to be higher to make up the shortfall — though he noted that no central bank has ever done that.
The point of a pledge to keep the overnight rate target unchanged for two years is that if investors believe it then yields two years out will reflect that rock-bottom overnight rate. But investors already seem to have accepted as gospel the Fed's view expressed repeatedly at policymaking meetings that high unemployment and stable inflation expectations "are likely to warrant exceptionally low levels of the
federal funds rate for an extended period." Dino Kos of Portales Partners, who formerly was in charge of the Open Market Desk, the unit at the New York Federal Reserve Bank that does the Fed's daily interventions in the money markets, said an unconditional pledge could help anchor investor confidence that the Fed would not begin raising rates anytime soon.
That would be a better way to try to keep longer-term rates low than setting a target for a three-year rate and intervening to achieve it, Kos said in an interview. On the other hand, two-year rates have come down sharply recently, an indication that the "extended period" language appears to be having the same effect, he said.
Another Option: No More Interest on Excess Reserves
Another idea advocated by some economists is that the Fed should move its current zero to 25 basis point target for the federal funds rate very close to zero and to stop paying interest at a 25 basis point rate on the nearly $1 trillion of excess reserves accumulated by banks after the central bank flooded the system with cash. Without that interest, banks would be more willing to make loans to replace that lost income, or so the argument goes.
However, banks can already make much more than 25 basis points on almost any sort of loan to a creditworthy borrower, even after adjusting for the risk inherent in such a loan. So it's not the interest from the Fed that is a barrier to lending.
And with a federal funds rate even closer to zero, the market in which banks lend to each other at that rate would disappear and money market mutual funds might have to shut down, according to Ward McCarthy, chief financial economist at Jefferies Group. "That would kill the interbank market that has been the mainstay of the banking system throughout modern times," McCarthy said in an interview. As for money market funds, there already have been huge outflows, and if the funds rate went to zero, there wouldn't be enough of a return to encourage investors to leave their money there, he said.
John M. Berry covered the Federal Reserve and the U.S. economy for the Washington Post for 25 years.