What the Federal Reserve Should Do

With Congress' stimulus appetite stuffed and short-term interest rates kissing the floor, you might think there's nothing more the federal government can do to pro-actively grow the economy. You'd find a lot of people who would agree with you, including many people running the country. But Joseph Gagnon isn't one of those people. For months, the former senior economist at the Federal Reserve has called for his old employer to bring down long-term interest rates to stimulate the economy. How would that work, exactly? He explains in the Economist:

First, the Fed should lower the interest rate it pays on bank reserves to zero...

Second, the Fed should bring down the rates on longer-term Treasury securities by targeting the interest rate on 4-year Treasury notes at 0.25% and aggressively purchasing such securities whenever their yield exceeds the target. That is a 75-basis point reduction from the current rate of 1%. 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...

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%.

The Fed can do all of these things, but it won't. Why not? It's about uncertainty -- truly, the word of the summer. The Washington Post's Neil Irwin explains:

The effect is particularly unclear in an environment where long-term interest rates are already very low; it's not evident that 10-year Treasury bond rates, to which mortgage and other rates tend to be linked, could fall much below their current 2.63 percent level.

Asset purchases could even be counterproductive, if they lead investors to think that the Fed will continue printing money indefinitely to fund large U.S. budget deficits, driving up inflation expectations. Although some uptick in inflation expectations could be desirable for the economy, the exact influence is unpredictable and expectations could get out of control quickly.

I see the debate like this. Imagine the recovery like a race between cars representing two forces: the lingering recession and the Federal Reserve's easy money. The Fed is cruising in fourth gear, but the hangover of the recession is still winning by a sizable margin. So backseat drivers are screaming for the Fed to shift into fifth gear and floor it. The Fed resists.

"I don't think this car can go any faster!" Bernanke says.

"But there's no harm in trying another gear!" the critics respond.

"We're not sure what that could do the car's transmission," he shouts back. And as a concession, he promises to continue flooring it in fourth. Unlike some to my left, I don't necessarily see this as an abdication of Bernanke's driving responsibilities. But vaguely reasoned uncertainty about the transmission system seems like a bad excuse to not shift up a gear.