Working on the Wrong Margins

Brad DeLongs offers some tepid support of yesterday’s FOMC outcome.

 At the moment ten-year Treasury bonds are selling at a present-value discount of20 14%, and thirty-year Treasury bonds are selling at a present-value discount of 45%. Guess that half of these discounts are expectations of interest rate changes and half are rewards for risk bearing. Then if the Fed buys half 10-year and half 30-year bonds it takes risk currently valued at $60 billion off of the private sector’s balance sheet. A ten-year corporate investment project of about $150 billion carries $60 billion worth of risk with it, so if this works and if the risk-bearing capacity freed-up by this version of quantitative easing is then deployed elsewhere, we will have an extra $150 billion of business investment over the year or so it takes to roll out this program and for it to have its effect.

Still, the outcome is too little:

$150 billion is, as Christina Romer likes to say “not chopped liver”–not even in a $15 trillion economy. But it is about 1/10 of our current problem–maybe less when you reflect that our current-problem is a multi-year problem.

I am skeptical that taking on longer-term US debt really draws off much if any risk-bearing capacity off the public’s balance sheet, thereby freeing up capacity for additional business investment.  I am even more skeptical that even if such risk were released, firms would take advantage.  There is plenty of cash already on corporate balance sheets, but little incentive to put it to work in an economic environment characterized by slow and uncertain patterns of growth.

I think market participants are also skeptical that this is even a marginally effective policy – note that as of last week, the ten-year TIPS breakeven was just a notch under 2%.  As of right now, the breakeven has plunged to 1.72%.  Not exactly a ringing endorsement of the Fed’s actions.  Indeed, quite the opposite – the Fed’s relative inaction is intensifying disinflationary expectations.

Simply put, it sure looks like the Fed is playing around at the wrong margins.  Barry Ritholtz summarizes:

There is no calvary coming to the rescue.

Will the calvary eventually come?  It will not be long before we are right back where we were last fall – a 1.5% ten-year breakeven, pushing the Fed toward another round of quantitative easing.  But will the Fed have the stomach to bring it out in meaningful quantities  to compensate for operating on the weak margins of monetary policy?  They need to stop thinking on the order of hundreds of billions and start thinking on the order of trillions.  And they need to be willing to allow inflation to rise above 2% to be most effective.  It seems, however, that this is too big a package to expect from the Fed.

Bottom Line:  We need policy that decisively lifts the economy off the zero bound.  Policies that work through traditional avenues, primarily the credit channel, have been ineffective.  Surely effective would be a cooperation between fiscal and monetary authorities – print the money and spend it.  We are faced with increasing expectations if disinflation coupled with fears to spend more because of the size of the deficit.  Should be more than ample room for policy coordination, and that policymakers are not more aggressive at this point is bewildering.  Inaction on the part of the Administration and the Federal Reserve is endangering them both politically.  The former is risking the White House, the latter is only adding fuel to the fire of right-wing criticism by engaging in half-measures with minimal, difficult to quantify results.  Caught in the middle is the American people, staring at the possibilty of another lost decade.

About Tim Duy 348 Articles

Tim Duy is the Director of Undergraduate Studies of the Department of Economics at the University of Oregon and the Director of the Oregon Economic Forum.

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