by Joseph E. Gagnon, Peterson Institute for International Economics
Op-ed in the Economist
August 17, 2010
© The Economist
It is now apparent that deflation is a more serious risk for the US economy than inflation. Both headline and core inflation are well below the 2 percent level that central banks view as optimal for economic growth and that the Fed has adopted as its goal. Recent bad news on economic growth and employment further increase the risk of plunging into outright deflation.
The case for monetary stimulus is strong. But what form should it take? With financial markets now in healthier shape, the Fed does not need to invoke the "unusual and exigent circumstances" clause to lend directly to the private nonbanking sector. Rather, it should return to its traditional roles of lending to the banking system and buying Treasury securities. Three actions, in particular, would be helpful at this time.
First, the Fed should lower the interest rate it pays on bank reserves to zero. This is a small step, as the current rate is only 0.25 percent, but there is no reason to pay banks more than the rate paid by the closest substitute, short-term Treasury bills. Three-month Treasury bills currently yield 0.15 percent, and that rate, too, should be brought down to zero.
Second, the Fed should bring down the rates on longer-term Treasury securities by targeting the interest rate on four-year Treasury notes at 0.25 percent and aggressively purchasing such securities whenever their yield exceeds the target. That is a 75-basis point reduction from the current rate of 1 percent. This step would also push down longer-term yields and reduce a wide range of private borrowing rates, encouraging business investment, supporting the housing market, and boosting exports through a weaker dollar. Moreover, pushing down yields on short- to medium-term Treasury securities is precisely the strategy for fighting deflation recommended by Ben Bernanke in 2002.
Finally, the Fed could bolster the stimulative effects of these actions by establishing a full-allotment lending facility to enable banks to borrow (with high-quality collateral) at terms of up to 24 months at a fixed interest rate of 0.25 percent.
These measures are all within the Federal Reserve's established powers. They pose essentially no risk to the Fed's balance sheet. Roughly speaking, they comprise a net easing of the stance of monetary policy equivalent to a 100 basis point cut in the federal funds rate. According to the Federal Reserve's own economic model, such a policy move would reduce unemployment roughly as much as a two-year, $500 billion fiscal package and yet it would actually reduce the federal budget deficit. And it can be reversed quickly should the balance of risks shift from deflation to inflation.
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