I don’t claim to have the answer to this question. Those who propose an answer other than “nothing” don’t get a lot of airtime, but Dean Baker, one of my favorite gadfly economists, is one of them. He writes today that it is wrong, wrong, wrong to say that the Fed has run out of ammunition. While it is true that the Fed has lowered its usual policy target, the federal funds rate, as far as it can go (0-0.25%) and blown through two unusual policy actions known as quantitative easing (QE), there are other options that every policy economist has heard about. (Whether they’re wise options or not is the real question.) I’ll turn it over to Baker:
‘The Fed could do another round of quantitative easing, although this is likely to have a limited impact. It could also target a long-term interest rate, for example putting a 1.0 percent interest rate target on 5-year Treasury bonds.’
QE3 might well happen, although as Baker notes the impact is likely to be limited, as was the case with QE2. Since QE2 did not seem to roil financial markets, my sense is that there will be a QE3, with a slight downward push on medium- and long-term interest rates. But given the low business and consumer borrowing with today’s low interest rates, I doubt that nudging them further down will make a noticeable difference.
Targeting a long-term interest rate implies a more aggressive form of QE, where the Fed buys and sells long-term bonds in such a way as to control the market for those bonds. This is more than it does in its open market operations for Treasury bills, which are about hitting a target for the fed funds rate (the interest rate on loans of reserves between banks), not controlling the T-bill rate. I’m instinctively a bit leery of handing that much control over the bond market to the Fed, and I suspect financial markets would like it even less.
‘Alternatively, the Fed could pursue a path that Bernanke himself had advocated for Japan when he was still a Princeton professor. It could target a higher rate of inflation, for example 4 percent. This would have the effect of reducing real interest rates. It would also lower the debt burden of homeowners, which could allow them to spend more money.’
I’m really skeptical of this one on two fronts.
- I don’t think it’s all that easy for the Fed to raise the inflation rate when the economy is stagnant. (The exception — stagflation in the 1970s — was a case where people lost all confidence in the Fed, and it’s not an episode anyone wants to repeat.) All the textbook models I’ve seen of inflation have it coming from either higher aggregate demand (the horse to inflation’s cart, not the other way around, and precisely what’s lacking in this depression) or from an increase in the money supply. And increasing the money supply is not as simple as dropping cash from a helicopter. In the real world the money supply increases as part of a multi-step process: the Fed gives banks excess reserves, banks willingly loan out those excess reserves to willing borrowers, those borrowers spend them, the cash gets deposited into bank accounts, which are part of the money supply. Note the “willing” parts in there — banks have to be willing to loan out their excess reserves, instead of sitting on huge piles of them as they’re doing now, and households and firms have to be willing to borrow money, instead of holding back out of economic anxiety.
- Doubling the Fed’s target rate of inflation (it’s now 2%, unofficially) would not only be a political non-starter, likely leading to Congressional hearings or legislation to change the Fed’s charter, but it seems to rely on massive money illusion, i.e., a public too stupid to know what the inflation rate is. Financial markets can make big mistakes, but ignoring the inflation rate is generally not one of them. As Irving Fisher noted a century ago, if the expected inflation rate jumps from 2% to 4%, then nominal interest rates will also jump by 2 percentage points, leaving expected real interest rates (the ones that matter) unchanged. It is true that real interest rates on old loans and the real burden of old debt would fall, which would be good for debtors and ought to provide a net stimulus to the economy. But creditors would regard a planned inflation hike to 4% as theft, which could not be good for confidence overall and might inhibit future lending. Raising the inflation target to the historic norm of 3% would be better, but then we’re back to the question in (1): How?
I’m still looking for alternative stimuli the Fed could try, including different forms that QE3 could take. If you’ve got any ideas, the comments section is happy to have ‘em.