The Perfect Stimulus: Free, Politically Viable, and Deficit-Reducing

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This might sound impossible, but the Federal Reserve and Treasury could make it happen

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This week, the talk in Washington was all about how the government can help to create jobs. President Obama offered his suggestions Thursday night. Earlier in the week, Republican frontrunner Mitt Romney provided his plan. Each has some good ideas, but they all have drawbacks: some will cost taxpayers money in the long run and most would require Congress to act. What if a stimulus proposal could sidestep Congress, cost taxpayers nothing, and actually improve the stability of U.S. borrowing?

The Idea: QE 2.5

The Fed's Role

The Federal Reserve would be responsible for one aspect of this stimulus. As you probably know, it has already conducted two rounds of monetary stimulus, or quantitative easing ("QE"). In the first round it purchased securities to help stabilize the financial system after the crisis threw it out of whack. The second round began last November, when the Fed announced it would purchase $600 billion in longer-term Treasuries over eight months.

Both QE1 and QE2 inflated the size of the Fed's balance sheet: they resulted in the Fed injecting additional money into the financial system and holding more assets in its portfolio. But with this new step, which I'll call "QE2.5," the Fed would just replace some of its shorter-term Treasuries with long-term Treasuries.

This possibility was suggested in the monetary policy committee's August meeting. But what if it were focused on purchasing even longer-term Treasuries than QE2: what if it targeted the purchase of only 10- to 30-year notes?

The Treasury's Role

The problem, of course, is that the Treasury doesn't issue many notes with such long maturities. The demand just isn't as great for those as it is for short-term notes. For example, in August the Treasury issued $721 billion in new securities, of which just $41 billion -- less than 6% -- had maturities of at least 10 years. But now imagine that the Fed wants to buy, say, $125 billion per month in longer-term securities for six months. The Treasury could shift is issuance accordingly to provide more longer-term notes to meet some of that demand.

The Motivation

The Fed's Rationale

So why would the Fed bother buying longer-term securities? Its demand for long-term securities would reduce long-term interest rates. Since the government would also be issuing additional securities, however, the effect would be a little more muted, which is why the size of the program would have to be fairly large, and probably larger than QE2.

By pushing longer-term interest rates a little lower, consumers or businesses that want to take on longer-term loans will have a stronger incentive to do so and spending should rise. Since the government would be reducing its issuance of shorter-term Treasuries, the relatively smaller new supply should prevent short-term interest rates from rising much when the Fed begins selling some of its shorter-term holdings.

The Treasury's Rationale

Why would the Treasury want more longer-term debt? Let's think of an analogy. Imagine that you had two loans: a 30-year mortgage fixed at 3% and a 1-year loan at 0.5% that you have to roll over annually. Although that one-year loan is cheaper now, you know that in a couple of years it will cost you more than 3% to continue to roll it over -- and your spending habit won't allow you to pay it off. As a result, it makes sense to consolidate that short-term loan into your mortgage if you are able.

This is similar to the government's situation. The long-term interest rates that it's facing are hitting record lows, due in large part to all of the troubles in Europe. Although its short-term debt is facing very low interest rates, eventually they'll rise. For example, the one-month T-bill yield is at a ridiculous 0.01%. That's great, but as recently as 2005, the same securities' yield was above 4%. Meanwhile, 10- to 30-year Treasury notes yields currently range from 1.93% to 3.26%. If the government locks in those very low rates, it will pay more at first, but could save taxpayers a great deal of money in the long run.

And really, that higher interest rate that the Treasury is paying won't be felt on the securities it sells to the Fed: it provides the Treasury its profits each year. So the vast majority of that interest will ultimately return to the Treasury anyway as Fed profit.

There's another big benefit here: the more long-term debt that the Treasury issues, the easier it will be to roll over its smaller shorter-term debt balance over the next few decades. Its reliance on shorter-term debt could create a challenge in future years as interest rates rise. Its interest costs will be much higher for securities it issues after the current environment of ultra-low rates ends.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.
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