What the Fed Can Do to Speed the Recovery
One option: bring down longer-term interest rates by putting a cap on the yields of government bonds.
During and immediately after World War II, the Fed successfully put an upper bound on long-term Treasury yields (at that time, 2.5%). It can do so again, by committing to buy 30-year bonds in the secondary market at sufficiently high prices to cap their yield at 0.5%, compared with the current 1.5%. This would, in turn, lower long-term borrowing costs for everyone from corporations to homebuyers.
This would be a much more effective way of undertaking quantitative easing, which also entails buying bonds to bring down long-term rates. The difference is that with QE, as practiced in the last decade, the Fed had a hard time predicting how much a certain amount of bond buying would move long-term yields. Committing to a yield cap and buying what’s needed to enforce it would be a lot more straightforward.
The approach raises two issues. The first is whether lower long-term rates will actually pass through to households (via mortgages) and businesses (via corporate bonds). If a disparity arises, though, the Fed can always tamp it down by buying mortgage securities and corporate bonds directly. Even the threat of such an intervention might be enough to keep rates in line.
Second, some might worry that a peg on long-term yields would provoke an untoward upward jump in inflation expectations. The Fed would of course need to be vigilant. At this point, though, an increase in inflation expectations would be desirable: Prices of Treasury securities suggest that investors currently expect inflation to run well below the Fed’s 2% target over at least the next decade.
The Fed has other options. One is forward guidance, in which the central bank seeks to influence interest rates today by divulging its plans for the future. During the slow recovery from the last recession, for example, the Fed announced that it intended to keep its short-term interest-rate target near zero for a couple years, with the aim of lowering medium-term borrowing rates (on auto loans, for example). Now, however, with the three-year Treasury yield already at 0.2%, it’s hard to see how forward guidance would make much of a difference.
Another option is medium-term yield curve control, in which the central bank would cap the yields of securities such as the 5-year Treasury note. Again, though, there’s not much one can do here without going into negative territory: The 5-year yield is only 0.4%.
The economy will start to rebound from the current slump in the second half of this year. The Fed can and should support this recovery. If it won’t go negative, then targeting long-term rates seems like the best it can do.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Narayana Kocherlakota is a Bloomberg Opinion columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.
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