Monetary Policy’s Role in America’s Economic Recovery

At this year’s Jackson Hole conference for central bankers, Fed Chairman Ben Bernanke admitted that the economic recovery so far this year has been “somewhat less vigorous than we expected,” but he expressed hope that the economy would return to a more satisfactory growth rate next year.  Considering that the Fed was already projecting a markedly slower recovery than America experienced after previous deep recessions, the Fed’s economic objectives are far too modest.  Ideally, the US economy should be growing at a 5 percent rate in 2010 and 2011 to recover lost ground and get workers employed.  It is important to recognize that it takes a growth rate of 2.5 percent just to keep the unemployment rate constant.  And the economy grew at a rate of only 1.6 percent last quarter.

According to the latest Federal Reserve forecast—prepared before this summer’s batch of bad news—it will take at least three or four years for employment to return to its long-run sustainable level.  This extended period of high unemployment represents a massive waste of productive labor and untold personal suffering of unemployed workers.  The Fed should be aiming to get us back on track within two years.  And the urgency of Fed action is all the more important because Congress has refused to provide more stimulus.

In addition, it is now apparent that deflation is a more serious risk for the US economy than inflation.  Both headline and core inflation have trended well below the 2-percent level that central banks view as optimal for economic growth and that the Fed has adopted as its goal.  Measures of inflation expectations also have fallen to historically low levels.

What Are the Forces Keeping the American Economy So Weak? 

The collapse of the housing bubble destroyed the financial health of millions of households.  These families are now struggling to pay off debts and rebuild their retirement nest eggs.  That means they are spending less on cars, home renovations, vacations, and other consumption that supports jobs.  Meanwhile, foreigners continue to use the money they earn from selling imports to Americans to buy financial assets rather than exports that support American jobs.  Business investment—the bright spot of the recovery so far—is not sustainable unless either consumption or exports grow strongly. 

What More Can the Fed Do?

Monetary policy can get us back on track by reducing the interest rates that people and businesses pay.  Households can refinance their mortgages and car loans at a lower interest rate that frees up money for spending.  Businesses can afford to expand when they are able to issue bonds and borrow from banks at a lower rate of interest.  And lower interest rates make US financial assets less attractive to foreigners, pushing down the dollar.  A lower exchange value of the dollar boosts US exports and creates jobs.

The Federal Reserve has already lowered the overnight interest rate close to zero.  But, as Chairman Bernanke affirmed in Jackson Hole, the Fed has several options to provide further support to the economy.  Three actions, in particular, would be helpful now:

• First, 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 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.  Pushing down yields on short- to medium-term Treasury securities is precisely the strategy for fighting deflation recommended by Chairman Bernanke in his famous “Deflation” speech in 2002.

• Second, the Fed could help banks to lend at lower interest rates through unlimited discount window credit to banks (with high-quality collateral) at terms of up to 36 months at a fixed interest rate of 0.25 percent.

• Finally, 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 it has important symbolic significance.  In particular, it would force banks to acknowledge that holding reserves at the Fed is a wasted opportunity when these funds could be lent to households and businesses at positive interest rates.  Chairman Bernanke has expressed concern that such a step would shut down the interbank market for overnight loans, but the experience of Japan shows that this market can bounce back when rates turn positive.  Moreover, the Fed itself can supply banks with overnight loans during any future transition period.

Would It Work?

These measures are all within the Federal Reserve’s established powers.  They pose very little risk to the Fed’s balance sheet and they will actually reduce the federal budget deficit.  More importantly, they will reduce the interest rates households and businesses pay substantially, thereby unlocking a considerable amount of extra spending.  According to the Federal Reserve’s model of the US economy, these measures would reduce unemployment roughly as much as a 2-year $500 billion fiscal package.  And they can be reversed quickly should the balance of risks shift from deflation to inflation.

The Fed’s actions last year already led to record-breaking corporate bond issuance in 2009, which enabled business investment to be the strongest component of the private economy.  They also sparked over a trillion dollars of mortgage refinancing, which provides long-lasting cash-flow benefits to struggling households.  The Obama Administration could make Fed action even more effective by demanding that Fannie Mae and Freddie Mac directly contact and approve for refinance all homeowners currently paying above-market rates on Fannie- and Freddie-guaranteed mortgages, regardless of employment circumstances.