Quantitative easing

Today’s announcement from the Federal Reserve marks the end of the road for Plan A (fighting the recession by lowering interest rates), and the beginning of … what?

The Fed’s announcement begins:

The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.

Although that caught the headlines, it’s really the anticlimactic part. The actual fed funds rate and short-term T-bill rates had been well below the Fed’s previous “target” of 1.0% for some time, making today’s announcement little more than an acknowledgement that that’s indeed where we are. At least we can all finally agree that further rate cuts from the Fed are completely irrelevant, if for no other reason than because it’s physically impossible for there to be any more ahead.

dff_tbill_dec_08.png

The main news value of the Fed’s announcement was the opportunity for the Fed to communicate what else besides rate cuts it may have in its bag of tricks:

The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

The frustration for the Fed is that while the T-bill rate is already essentially zero, term rates charged to any of the rest of us remain far higher. The Fed continues in its hope that by changing the composition of its assets– making loans itself, buying MBS– it will be a big enough factor in the demand for the less favored assets to move those spreads. This of course is exactly the kind of thing that the Fed has been doing for the last year, with the FOMC today promising an even bigger expansion of its holdings of unconventional assets.

fed_blnc_dec_08.pngWSJ reports this clarification on what the Fed intends from a press conference with a “senior Federal Reserve official”:

Is this quantitative easing? The Fed said in its statement today that it will be using its balance sheet to support credit markets and the economy. Some analysts have called the approach quantitative easing– effectively expanding the money supply once interest rates cannot be eased further– as Japan did during its economic turmoil.

But the senior Fed official said the central bank’s approach is distinct from quantitative easing and different from what the Japanese did. The Fed’s balance sheet has two sides, the official explained: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan’s quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed’s focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. That’s designed to improve credit-market functioning, the official said. By expanding the balance sheet by making loans, the official explained, the focus is not on excess reserves but on the asset side. That securities-lending approach directly affects credit spreads, which is the problem today– unlike Japan earlier, where the problem was the level of interest rates in general, the official said.

Will that strategy succeed if we just do it on a sufficiently large scale? I’m not at all convinced that it would. Our standard finance models treat interest rate spreads as governed primarily by fundamentals such as default risk and only secondarily by the volume of buyers or sellers.

But while the Fed may have little control over the spreads between different interest rates, it does have a significant degree of control over the inflation rate. The 1.7% drop in headline CPI during November, and the -10% annual deflation rate for the last 3 months, should not be viewed as welcome developments in an environment where our primary concern is whether individuals and institutions are going to repay their debts. The Fed should want to generate enough inflation to pull those short-term interest rates above the zero floor. But to target inflation, the Fed would take exactly the opposite strategy from that outlined by the senior Fed official above. The goal would be to get cash into circulation rather than be hoarded by banks, and have the Fed’s assets be ones that could be readily liquidated if the inflation starts to come in higher than desired.

Greg Mankiw wishes the Fed had added to its statement something along the following lines:

The Committee recognizes that moderate inflation would be desirable under the present circumstances. In particular, the overall level of prices a decade hence should be about 30 percent higher than the price level today.

And I like Greg’s explanation of why that’s the direction we need to go:

As Jim Tobin said in an earlier era, there are worst things than inflation, and we have them.


Originally published at Econbrowser and reproduced here with the author’s permission.