Should the Fed Do More?

Johns Hopkins University Professor Larry Ball, Princeton Professor Paul Krugman, U.C. Berkeley Professor Brad DeLong, University of Oregon Professor Tim Duy and Texas State University Professor David Beckworth are among those recently arguing that Fed Chairman Ben Bernanke is neglecting his own earlier academic insights into what the central bank should be doing in a situation such as the United States presently finds itself. Here’s what I think they’re overlooking.

These academic critics would like to see the Fed announce more aggressive targets in the form of either higher rates of inflation or faster growth of nominal GDP. I will get to the issue of these targets in a moment, but first would like to discuss the mechanical details of what, exactly, the Fed is supposed to do in the way of concrete actions in order to ensure that any such announced target is achieved.

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:

of all the stories you’ve heard why unemployment is stubbornly high, how plausible is this: “The main problem is the maturity structure of debt. If only Treasury had issued $600 billion more bills and not all these 5 year notes, unemployment wouldn’t be so high. It’s a good thing the Fed can undo this mistake.”

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.

Perhaps there is a clear way to communicate an alternative, more ambitious goal, such as keeping nominal GDP growth above 5%, or temporarily focusing on getting unemployment down to 7%. If articulated narrowly and with some caution, these might allow the Fed to do more while still preserving confidence in what I have described as the logistics of managing potentially volatile short-term government debt.

But unlike many of my fellow academics, I worry about those logistics and am convinced that it is a mistake to ask too much from monetary policy.

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