Should the Fed do more?



The primary tool available at the moment is large-scale asset purchases, in which for example the Fed buys longer term Treasury securities with newly created reserves. These reserves are simply accounts banks hold at the Fed, which funds the banks could redeem for cash or use to buy an asset from somebody else any time they wished. From the point of view of the bank that holds those reserves, they are an asset very similar to short-term T-bills, being highly liquid and paying a very low interest rate. I think it is most accurate to think of large-scale asset purchases as the government shortening slightly the maturity structure of its outstanding debt, leaving the public holding fewer long-term bonds and more reserves. There are a number of recent academic studies that have evaluated the potential effects of such an operation, which generally conclude that massive purchases could modestly reduce long-term interest rates and thus potentially provide some stimulus to aggregate demand. But note well that the Treasury could achieve pretty much the same effect if it were to do less of its borrowing with 10-year bonds and more of its borrowing with 3-month bills.

So a natural question is, why aren’t the above academics taking aim not at the Fed but instead at the Treasury for issuing so much long-term debt in preference to short-term debt in the first place? If we phrase the question this way, the answers should be obvious. First, as noted by University of Chicago Professor John Cochrane, once you spell out exactly what the operation consists of, it’s hard to expect huge economic benefits of large-scale asset purchases:


Maybe it would help a little if the Treasury did more of its borrowing short-term, but who could possibly expect that to be a panacea?

Second and more importantly, suppose the same academics were to descend on the Treasury in force, insisting that the government rely more heavily on short-term borrowing. Let’s say, to take a dramatic example, we propose to move the entire $10+ trillion in current publicly held debt, along with each month’s additional new net borrowing, into 4-week bills. Couldn’t we all agree that such a move would recklessly endanger the government’s ability to manage its weekly debt financing? Sure, at the moment, it might be possible to find $10 trillion in buyers each month. But conditions and sentiments can easily change, and would be particularly likely to do so if the refinancing logistics were as inherently vulnerable as exclusive reliance on short-term financing would render them. The U.S. isn’t Greece, these academics insist, and I agree– at the moment, we’re not. But that’s a result of the situations we allow ourselves to be placed in, not an immutable law of nature.

And reserves are an even more volatile form of government borrowing than Treasury bills. Deposits with the Federal Reserve are a liability of the Fed that can be redeemed immediately at will rather than having to wait 4 weeks to decide whether to roll the debt over again. But, some may argue, reserves are different in that they aren’t destroyed by private sector decisions. If I decide I’d rather have, say, yuan or gold instead of my dollars, I can use the reserves to make that purchase. But although I’ve gotten rid of my reserves, the bank of the person who sold me the yuan or gold now has the reserves instead, and maybe they don’t want them either. Equilibrium is restored by prices of goods and assets adjusting until people in fact want to hold the reserves after all, for example, I get so few yuan or so little gold for each dollar that I figure I might as well hold the dollars.

One tool for ensuring that the supply of reserves equals the demand would be for the Fed to raise the interest rate it pays on reserves. This would encourage banks to continue to hold the reserves, and is exactly the same kind of option that would be available to the Treasury if buyers balked at rolling over its debt. The Fed could try to persuade banks to hold reserves by raising the interest paid on them, the Treasury could try to persuade lenders to participate in the auction by raising the interest paid on T-bills. The problem is, if investors lose faith in the refinancing logistics themselves, the outcome in either case could turn out to be quite a high rate of interest and a chaotic, highly destructive process.

I think that’s why most of us would agree that it would not be a good idea for the entire U.S. debt to be solely in the form of 4-week T-bills or deposits with the Federal Reserve.

And it’s why I also believe that large-scale asset purchases can not, by themselves, be viewed as a solution to the current disappointingly slow U.S. economic growth.

My view is that instead large-scale asset purchases are most effective when used as a communication tool by the Fed, as a concrete follow-up action the Fed could implement in order to achieve certain stated goals. The task then is to identify what those goals are, communicate them credibly to the public, and count on large-scale asset purchases as the Fed’s big stick.

And the way I see current U.S. monetary policy is exactly as Bernanke defended it at a recent press conference. I believe the Fed has effectively and credibly communicated that it is not going to allow the U.S. to repeat Japan’s experience of deflation or extremely low inflation. Deflation is the exact opposite of the potentially chaotic flight from dollars that I described above, and deflation would unquestionably be counterproductive for the U.S. By drawing a line at keeping inflation above 2%, I think the Fed can use its limited available mechanical tools in a credible way to achieve an appropriate goal.




37 thoughts on “Should the Fed do more?

  1. JLR

    Thank you. I was wondering about the logistics myself. This explained the issue well.

  2. Lord

    I am not so sure he hasn’t retreated from 2% as the midpoint to 2% as the ceiling for the core and the bottom really sounds like 1% not 2%.

  3. AS

    Regarding borrowing along the yield-curve, is there any value in having a degree of “certainty” in the rates that the U.S will pay to borrow? Currently five-year treasuries yield about 0.84 %, ten-year obligations yield about 2.0% and twenty-year obligations yield about 2.8%. These rates compare to 2005 when five-year obligations yielded about 4.0% and ten-year obligations about 5.0%. If inflation increases dramatically in the next few years, it seems beneficial to have some or a lot of debt at fixed rates for a five, ten or twenty year period.

  4. Nick Rowe

    If a (say) 5% NGDP level path target (with a catch-up step) were credibly communicated, all those “mechanical” and “concrete” “logistics” would have to be implemented very quickly, only in the exact reverse direction. The Fed’s balance sheet is far larger than it would need to be if people expected 5% NGDP level path. The more ambitious the target, the easier the logistics.

  5. JDH

    Nick Rowe: Not sure I’m following your argument. I gather your claim is that the announcement itself would solve the problem. If so, I’m skeptical about that assumption. I am just looking at the mechanics of what the Fed would do right now, with numbers and the situation such as we have, in order to boost nominal GDP growth. And my answer is, it would have to do more buying of securities, leaving bigger concerns than those we have right now as to how later the Fed is going to go about undoing those positions.

  6. Anon1

    Really? What happened to the old Jim Hamilton who wrote this in 2010:
    “The claim that a central bank could become completely unable to debase the currency if it wanted has always seemed odd to me. Even if reserves and T-bills become equivalent assets (and at the moment they surely are), reserves are not equivalent to any number of other assets. Nothing prevents the Fed from buying longer-term assets, continuing to create reserves at will for the purpose until the yields on those assets adjust. And yet, the Fed has bought over a trillion dollars worth of mortgage-backed securities, and we’re still not where we want to be.

  7. JDH

    Anon1: Not sure I understand your point, either. I claimed then and still claim today that the Fed has the power to prevent deflation.

  8. Nick Rowe

    James: Assume, just for the sake of argument, that the announcement of higher NGDP growth is 100% credible, immediately. With a mixture of higher expected inflation and higher expected real growth, nominal and real equilibrium interest rates would have to rise, not fall, otherwise Aggregate Demand would be so strong that actual NGDP growth would exceed the expected and targeted 5%. The demand for money (especially the demand to hold reserves at the Fed) would fall too. The Fed’s balance sheet would have to shrink to about the same size that it was before the recession.
    All the mechanical policy levers would have to be moved in the exact opposite direction to prevent the economy overheating and overshooting the 5% NGDP target. In which case, just how “mechanical” are those levers? Just how concrete are the concrete steps of the logistics? The relation between the policy instruments and the policy target variables isn’t even monotonic. The Fed *threatens* to move them one way, conditional on the target variable being below target, but actually moves them the other way when the target variable rises to the target.

  9. Simon van Norden

    I’ve seen a lot of debt crises and the concentration of govt. debt in short maturities is one of their hallmarks (if not a prerequisite.) But another hallmark (if not a prerequisite) is that the debt is denominated in a currency which the government cannot readily supply (e.g. “hard” currency or gold.) That doesn’t seem to apply to the current stock of US debt.
    I’m also not sure that I correctly understand your argument about the options facing the Federal Reserve in the hypothetical case where (1) there is “lots” of short-term debt and (2) investors start to lose confidence in its orderly refinancing. Am I right in thinking that the Fed then must choose between a combination of the following 3 options?
    1) Raise the interest rate on S/T debt (potentially “a chaotic, highly destructive process.”)
    2) Allow the USD to depreciate to the point where investors are happy to hold the debt (i.e. they expect appreciation to take the place of higher interest rates)
    3) Convert reserves on demand into fiat currency.
    Is that the tradeoff the Fed would face? (Let’s ignore retroactive legislative measures, banking holidays, etc.)

  10. Anon1

    You asked in today’s post exactly what the Fed could do to raise inflation further. And in your 2010 post on preventing deflation you provide the answer. Use the same tactics to hit higher inflation that you would use to prevent deflation. These tactics don’t suddenly become ineffective once positive inflation is hit.
    Yes, these tactics would work best–or even just used as a threat–when used with a publicly communicated commitment to higher inflation. But you seem to be questioning that there are any tactics at all and that seems strangely at odds with your earlier post.

  11. 2slugbaits

    I have to agree with Lord. Officially the Fed still says that a 2% inflation rate is the target; but the Fed hawks have successfully made that a 2% ceiling. In any event, I think JDH has missed much of the criticisms leveled against Bernanke. There are certainly plenty of rationalizations for inaction and no guarantee of success. But Bernanke is more afraid of staining the Fed’s reputation than he is in actually doing everything he can to bring unemployment down. Committing to a higher inflation target is, as I read it, the main recommendation coming from the Fed critics. I don’t think Bernanke is being criticized because of the term structure of the debt except to the extent that the term structure affects inflation. But one of the Fed’s problems is that they cannot credibly commit to a higher inflation target just by making an announcement to that effect. That’s why adopting risky policies that would effectively commit the Fed to higher inflation are what’s needed. Cortez burned his boats; Bernanke needs to do the same. Since Bernanke fully recognizes that the risks of deflation and inflation are not the same, I simply do understand why the Fed behaves as if the loss function is the same. The consequences of undershooting the 2% target by one percentage point are much graver than the consequences of overshooting the target by one percentage point.
    The majority of the blame still lies with Congress and to a lesser extent the Treasury, but the Fed’s hands are not entirely clean either.

  12. Simon van Norden

    One problem I have with the Bernanke critics Jim mentions at the outset is they seem genuinely (?) confused by the conflict in views between those written by Bernanke as a academic stating his personal opinion and his statements on behalf of the Board. I have no doubt that the opinions of a Board with members such as Fisher, Plosser and other inflation hawks can often differ from the personal views of its current chairman. I would be very surprised to hear a Fed Chairman publicly describe how and why his personal views are at odds with those of the Board.

  13. Anonymous

    What about the Fed’s purchases of assets other than long-term Treasury bonds? How are the mechanics different if the Fed is buying mortgage backed securities? Because this is affecting interest rates in a different market, right? Additionally what if the Fed decided to purchase a whole new class of assets, for example credit card loans or student loans? Do you think this is a reasonable way to stimulate aggregate demand that could potentially have a bigger impact than just buying more long term Treasuries?

  14. Bill Woolsey

    If there were no zero bound problem, then financing the national debt T-bills rather than bonds and notes wouldn’t matter much. However, if it T-bills are temporarily the same as money, then it isn’t at all obvious that increasing the quantity of money to 14 trillion would have no effect.
    On the other hand, I think it is the Fed’s job to maintain nominal expenditure in the economy, and so that is who I criticize.
    Also, the risk element of this follows from basing the finanical system on zero interest government currency. Negative nominal interest rates are an alternative to having the Fed purchase lots of risky assets.
    I agree with Rowe, however, that a clear committment to a nominal GDP level target–and a willingness to make whatever asset purchases are necessary, would likely result in higher nominal interest rates and a need for the Fed to shrink its balance sheet now.

  15. Andy Harless

    JDH: Let me quote from this very blog a few years back:

    Have you changed your position on the efficacy of monetary policy at the zero bound? (Surely if it’s effective for preventing deflation, it will also be effective for raising the inflation rate when it’s already positive. And the forecast inflation rate is below the Fed’s target.)
    The real tool that the Fed has, potentially, though, I think, is not the assets it can buy today but the commitments it can make about what it will do at some future time when it is no longer constrained by the zero bound. It need not buy anything except short-term T-bills, but if it can promise to return eventually to a pre-set path for some nominal variable, then it could, in the first instance, wait out the zero bound and then move aggressively simply by buying (or continuing to hold) T-bills. But presumably, if the Fed made such a commitment, private agents would anticipate this future action and start shifting expenditures from the future to the present, so the Fed wouldn’t have to wait very long to wait out the zero bound.

  16. Brian

    (This isn’t totally my own idea, but I’m not sure where I read it previously. Did Bernanke himself come up with this in the ’90’s?)
    The problem is that the Fed is increasing its balance sheet, but the banks are holding their excess reserves at the Fed rather than going out and make loans. What if Congress and Treasury decided to send every man, woman, and child a check for $2000, financed by selling a special-purpose bond. The Fed agrees to buy all the bonds initially. That essentially puts money the Fed creates directly into the hands of consumers, bypassing the banking system.
    When the Fed is ready to start tightening it could sell these bonds in the market, where they would most likely trade just like any other Treasury security.
    That would inject roughly $600 billion into the economy, or roughly 4% of GDP.
    I can see this idea appealing to Keynesians with its emphasis on giving the consumer money to spend. On the other hand, consumption smoothing/forward-looking behavior suggests that for those who are not currently financially constrained or unemployed, the stimulative effects would be small. Would be an interesting experiment though…

  17. Charlie

    What if Bernanke just said, “we would happily tolerate 4 or 5% inflation. We wouldn’t raise the fed funds rate in that environment with unemployment high.” Wouldn’t that be seen as a huge change in Fed policy? Would it change the implied inflation in the TIPS markets? I think the driver of monetary policy right now is expectations of future Fed policy. Monetary policy isn’t more accommodative, not because of mechanical reasons, but because the market knows the Fed doesn’t want to be more accommodative.
    Even during last year, there were 3 dissenters at the FOMC meetings. The median voter on the FOMC didn’t want to raise the inflation target. You seem to think that if there were a bunch of Charles Evans’ on the FOMC, then Fed policy would still be unchanged, but I think both you and Cochrane are wrong.
    Of course, even Cochrane thinks the Fed could do something. He just thinks they need a new tool:
    I think the Fed has exactly the monetary policy it wants, so it’s hard to say that they have a commitment problem.

  18. dwb

    Its better to ask too much than too little. If the Fed does nothing the outcome is certainly bad.
    As long as unemployment remains high mortgage delinquencies will remain high. About 25% of homeowners are underwater; when they become unemployed, they default.
    the home price decline, foreclosure, delinquency cycle will continue to churn while unemployment remains abnormally high. “normal” delinquency rates wont be achieved until we get to ~6% UE – even then they will be higher than normal for a long time due to negative equity overhang.
    Declining home prices factors into purchase decisions, lending standards, new home construction.
    Until the Fed commits to close the output gap, this will all continue.
    Even worse, we dont know what the next Japanese Tsunami or political crisis is around the corner and the Fed has not bought ANY insurance.
    bad, bad risk management.

  19. Chicken

    I’d be willing to bet there are at least few large participants who are somehow able to consistently front-run the FED.
    Nice work if you can get it, but I wonder about how this eventually distills into wealth creation more than perhaps, simple transfer of wealth.

  20. Walter Sobchak

    I am just a citizen and one who is being impoverished by Federal Reserve policies.
    What I see is the world’s most improvident debtor (the US Government) being treated by a pill pushing doctor (Bernanke) who is feeding his patient a drug (inflation) that will kill him more likely than it will cure him.
    Not only that but the Federal Reserve is running the most over leveraged bank on the planet with 2,869G$ in assets being carried by 54G$ in capital, a leverage ratio in excess of 50.
    The Fed cannot change the level of employment. They don’t have guns to force private individuals to engage in productive employment relationships.
    The Fed tried to prop up the housing market by lowering interest rates, it failed. The problems in the housing market, including: excessive production in the wrong places, unemployment that makes potential homeowners financially incapable of homeownership, the enslavement of an entire generation to education lenders, the aging and impoverishment of the odious baby boomers, the collapse of the Fannie Freddie twins; are all far beyond the ability of the Federal Reserve to address. Congress can address some of them, some of them will just take time to work out.
    Wise policy would unwind that Fed’s balance sheet before it explodes. Wise policy would tell Congress and the President that the banking system cannot cover up for their irresponsibility. Wise policy would stop these fools before they do something so horrendously bad that future generation will spit every time their names are mentioned.

  21. anon

    “I am just a citizen and one who is being impoverished by Federal Reserve policies.”
    If you’re a saver, you’re being impoverished by the depressed economy and low natural interest rates. You should call for the Fed to stabilize the nominal economy, so that real returns on investment can reach higher levels (which happens as soon as the temporary liquidity effects of easing are played out).

  22. JSeydl

    I disagree.
    There is nothing magical about the line that separates low inflation and deflation. Just because the Fed has avoided deflation doesn’t mean that it has avoided a Japanese-style liquidity trap. Low inflation makes firms less confident that they will be able to sell their goods and services at a higher price in the future, leading to less investment. Deflation obviously does the same thing. One could make the case that inflation in the U.S. today is “low” because there was never a catch-up period of higher inflation to compensate for the collapse in prices in late-2008.
    Plus, you proved that your whole spiel about the mechanics of QE are irrelevant when you said that the underlying issue is a communication strategy. Of course an NGDP target would be a better communication strategy than the Fed’s current stop-and-go QE strategy. The issue is that the Fed needs to make it clear that it is willing and prepared to lift short-term rates off their lower bound in the future. Stop-and-go QE measures don’t accomplish this, because they convey a message of Fed passivity to the public. An NGDP target gets around this by making a commitment that the Fed is going to lift short-term rates off the lower bound, so “you better go out and borrow and invest now at today’s great deal.” The passivity embeded in stop-and-go QE measures tell firms that the great deal is going to be around for a while, so there’s no need for action right now.

  23. dwb

    by the way, for People of the Concrete Steppes who think QE needs to have a real channel (not merely signalling), i cite the following mechanism:
    – Lots of bank economists sit on capital committees and planning boards and feed their assumptions into CFOs business plans.
    -those economists also are deeply familiar with fed policy, fed forecasts, and other eminent economist’s blogs like this one (yes, some of these blogs get cited the work is excellent)
    -therefore when the Fed says they are committed to lowering the UE rate more quickly banks and business economists update their assumptions, which feed into lending, capital, and other business plans.
    -some economists also work at investment banks and work their assumptions into presentations which influence CFOs
    and that is the signalling “mechanism” of QE.

  24. Walter Sobchak

    “You should call for the Fed to stabilize the nominal economy … (which happens as soon as the temporary liquidity effects of easing are played out).”
    Dead is stable. More stable than growing.
    4 years after the the Fed donned its clown shoes balance sheet, the idea, that we are awaiting the end of temporary, is laughable. Temporary would have been a few months, 4 years, with noises about continuing to 2014 is not temporary any more. Bernanke’s term of office will end before temporary does, and I will join the masses of protestors calling on him to be sent back to Princeton where he can do less damage.
    Japan is not an example for those of you who think that the Fed can push a few buttons and make the economy work again. The Japanese have been pushing those buttons for over 20 years, and the only thing they have found out is that the buttons aren’t connected to anything.

  25. Joe Gagnon

    The Cochrane quote is just silly. No one says Treasury borrowing policy (or insufficient QE) caused the recession. The point is whether QE can help us recover faster. The conventional wisdom is that it would be dangerous to have all our national debt in short-term bills. The conventional wisdom is wrong. The Federal Reserve has complete control over the bill rate and should always set it to keep the economy on a stable growth path. There will never be a spike in Treasury borrowing costs unless the Fed believes that is necessary for economic stability. This is very different from the situation in Greece, which has no central bank continuously setting the Greek bill rate to suit the needs of the Greek economy.

  26. datacharmer

    The zimbabweans did exactly that – altered the term structure of debt by printing currency rather than issue longer-term debt – and got hyperinflation, no problem. Why would it not work with the fed?
    This is word-game analysis. Altering the long-term structure of debt can be a panacea.

  27. Basho

    If the Fed can’t create inflation, why not have it buy the entirety of the US government’s debt?

  28. Walter Sobchak

    “The Federal Reserve has complete control over the bill rate … There will never be a spike in Treasury borrowing costs unless the Fed believes that is necessary for economic stability.”
    There is a distinct possibility that the author of those words intended them as a kind of irony or satire. After all, no sane person thinks that a seller who has not physically imprisoned its customers could ever believe that the customers might not want to buy what the seller is selling.
    Or is this really what the Fed says to itself. That would be very frightening.

  29. don

    Good post, which adds perspective, and a lot of good comments.
    If I caught the point, the question is not whether the Fed can create inflation, but rather the choice may be between sudden and extremely disruptive inflation and unsatisfactory growth.
    I think we are in a worse situation than Japan in at least one respect. In my view the only substantive influence of QE is through effects on the dollar carry trade. But the world’s second biggest economy (and part of its trading bloc) stays locked to the dollar and the rest are not big enough to hold us up, so we can’t look to our trade balance to help us out of this mess. Even though Japan started with a bigger bubble and debt overhang, the yen carry trade gave them more help than we can expect from the like policy.

  30. don

    Despite the quality of comments, I am reminded (by Hume) that alternatives removed from recent experience have less weight in our considerations. Some time ago, on this site, I recall the opinion that the Fed should always be able to combat deflation, and without too much difficulty. That view, at least, is now subject to question. I sincerely hope that the view implicit in some of the above comments, which is that the “full faith and credit” can never come under serious doubt, does not meet the same end.

  31. Anonymous

    Why should we expect monetary policy to solve real as opposed to nominal problems?

  32. dwb

    “Why should we expect monetary policy to solve real as opposed to nominal problems?”
    the process of mortgage-delinquency, charge-offs, home price declines will continue until unemployment reaches normal.
    about 25% of homeowners are underwater and many are paying down principal .. or if they lose their job, default.
    Increasing nominal income accelerates the process, which in turn reduces the pressure on home prices and the housing/construction industry and therefore accelerates unemployment declines, especially in the contruction industry.
    That is certainly one mechanism. there are many others.

  33. Thorstein Veblen

    Yes, very good comments above…
    If we are in a liquidity trap, with the Fed powerless to cause inflation — then you should be a passionate advocate of large amounts of permanent QE. If it really did nothing, then the only benefit/detriment would be that it would reduce the federal debt, which seems like an unmitigated plus.
    All the recent evidence suggests that QE does move the stock, bond, and FX markets, just as a simple supply and demand graph would predict.
    Also, QE and the Treasury switching to ST debt may have a similar outcome, but clearly different.
    So, I can’t help suspect you are against further Fed action due to some strange ideological reason. Maybe you just feel that 2% core inflation is the perfect inflation target, and that mass unemployment and slow growth are small prices to pay to avoid 3% core inflation. In any case, the debate should move to whatever your real issues are.

  34. dwb

    i dont see the evidence for your claims. quite the contrary, your link suggests: “The growth in durable goods purchases occurred at a time when weekly unemployment claims were trending down and consumer confidence was rising. With workers feeling more secure about their employment prospects, more people moved forward with big-ticket purchases that were put on hold during the recession.”
    keep in mind that an increase in *nominal* personal income decreases the share devoted to fixed debt payments. It’s a little misleading to talk about real PDI in the context of mortgage equity withdrawal and deleveraging: *real* PDI includes an imputed cost for rental prices, which does not in fact change for the 25% of homeowners who are underwater (or if you have a mortgage in general). To correctly look at the impact deleveraging, you need to back out imputed costs and factor in the (decreased) value of nominal debt as a share of PDI.
    I dont see any evidence that increased nominal income would fail to accrue to wages and compensation through the usual channels (as a share of PI).

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