A lot, actually. We know this because (1) Fed officials believe there is much more they could do if they wanted and (2) monetary policy has been shown to be highly effective in far worse situations. The problem is the Fed has been reluctant to act so far. It has failed to pull out all of its big guns though there are some rumblings it may be considering doing so.
So what exactly are the big guns the Fed could employ in our current situation? According to these Fed economists there are three big guns that could be used:
(1) [S]haping the expectations of the public about future settings of the policy rate, (2) increasing the size of the central bank’s balance sheet beyond the level needed to set the short-term policy rate at zero (“quantitative easing”); and (3) shifting the composition of the central bank’s balance sheet in order to affect the relative supplies of securities held by the public.
The first big gun is in my view the most important one and can be restated as shaping expectations in general, not just expectations about the policy interest rate. Here the main idea is to convince the public that Fed is committed to a higher inflation rate or price level for the foreseeable future. This would lower current real interest rates, decrease the demand for money (i.e. increase velocity), and help stabilize (and maybe even restore) household and other troubled balance sheets. Currently, however, this big gun is just sitting in the Fed’s arsenal collecting dust. The other two big guns, as is well known, have been used as seen by the enlargement and asset alteration of the Fed’s balance sheet. While these big guns have been effective in stemming the credit crisis they have been less effective in stabilizing velocity. What has been frustrating about the Fed’s choice of the big guns to use so far is that there is reason to believe the first big gun by itself would have accomplished as much or more than what the second two big guns have done. This first big gun was used during the Great Depression by FDR with much success and suggests it should have been tried already by the Fed. Here are those same Fed economists on this experience:
An historical episode that may illustrate this channel at work (although the policymaker in question was the executive rather than the central bank) was the period following Franklin Roosevelt’s inauguration as U.S. president in 1933. During 1933 and 1934, the extreme deflation seen earlier in the decade suddenly reversed, stock prices jumped, and the economy grew rapidly. Romer (1992) has argued persuasively that this surprisingly sharp recovery was closely associated with rapid growth in the money supply that arose from Roosevelt’s devaluation of the dollar, capital inflows from an increasingly unstable Europe, and other factors… Temin and Wigmore (1990) [argue] that the key to the sudden reversal was the public’s acceptance of the idea that Roosevelt’s policies constituted a “regime change.” Unlike the policymakers who preceded him showing little inclination to resist deflation and, indeed, seeming to prefer deflation to even a small probability of future inflation, Roosevelt demonstrated clearly through his actions that he was committed to ending deflation and “reflating” the economy. Although the president could have simply announced his desire to raise prices, his adoption of policies that his predecessors would have considered reckless provided a powerful signal to the public that the economic situation had fundamentally changed. If one accepts the Temin-Wigmore hypothesis, then it appears that the signal afforded by Roosevelt’s exchange rate and monetary policies were central to the conquest of deflation in 1933-34.
So altering expectations here required both substantive action–actual sharp increase in the monetary base–as well as a public perception of a regime change by FDR. These actions worked and according to Christina Romer were the main reason for the robust recovery of 1933-1936. This experience suggests something similar should be done by the Fed today. So how could Fed employ this first big gun now? First, the Fed needs to to introduce an explicit inflation, price level , or nominal GDP target (my preference is for the later) and say that it is committed to this target no matter what it takes. Second, it needs to accompany this move with a PR blitzkrieg that makes it very clear this is a game changer, a real regime change. Of course, all this assume that the Fed decides that it wants to make such changes. Currently it is not clear that all Fed officials would welcome such changes.
Hopefully there are some folks inside the Fed who are listening. At a minimum I hope the Fed economists cited above are listening. One of them happens to lead the Fed.