Greg Ip

Articles by The Economist’s U.S. Economics Editor

A roadmap for more Fed easing

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 Dec 4th 2009, 0:35 by The Economist | WASHINGTON

[Greg Ip] THE Federal Reserve by law is supposed to strive for stable prices and full employment. It has had great success on the first part, but with unemployment around 10%, it’s been an abysmal failure on the second. My colleague across the hall has noted the oddity of Ben Bernanke being grilled at today’s confirmation hearing on how to regulate banks but not on how he plans to get unemployment down.

Mr Bernanke might answer that with the federal funds rate around zero he is already doing all he can. He’d be wrong. Joseph Gagnon at the Peterson Institute (and a former senior staffer for Mr Bernanke at the Fed) has a new paper (PDF) that offers very specific advice on what more the Fed can do. Namely: buy an additional $2 trillion in government bonds, with an average maturity of 7 years. That would be in addition to the $1.75 trillion of Treasury and mortgage-related debt it has already almost finished buying.

Mr Gagnon, extrapolating from the reaction to the current purchase programme, estimates the additional $2 trillion would lower Treasury yields about 0.75 percentage points. That, he reckons, would lower private borrowing rates, boost stock prices 13%, and lower the dollar by 5%. The combined stimulative impact would equal a 1.75 percentage point cut in the federal funds rate, and lift GDP by 3% after two years.

There would be no effect on the dollar if other central banks also ease monetary policy further, as Mr Gagnon advises. Specifically, he calls on the European Central Bank to lower its refinancing rate to 0.5% from 1%, purchase €1 trillion of long term securities, and continue offering unlimited 12-month funding to banks. The Bank of Japan should set an inflation target of 1% (inflation is currently -2.2%), purchase an additional ¥100 trillion of securities, and commit to buying a similar amount if core inflation over the next 12 months remains negative. The Bank of England should buy an additional £200 billion worth of long-term bonds or the equivalent of foreign currency bonds, hedged with currency swaps.

This may sound radical but as Mr Gagnon notes, unemployment in all these countries is projected to either rise or remain painfully high for the next two years. The gap between America’s current unemployment rate and its natural rate is the largest since the Great Depression. Based on baseline forecasts alone, more monetary stimulus is easily justified. Based on the tail risks around that forecast, the case is even stronger; such a large output gap could turn low inflation into pernicious deflation. There are risks of inflation and bubbles on the other side, but as Mr Gagnon notes, these are easily dealt with, either by rapidly tightening monetary policy (in the first case) or aggressive regulatory intervention (in the second).

As befits a Fed alumnus, Mr Gagnon’s work is technically elegant. I don’t doubt that many of his former bosses at the Fed, Mr Bernanke included, agree with his premises; they may even find the specific estimates reasonable. But the barriers to further quantitative easing at the Fed aren’t economic, they’re political. The Fed was taken aback by how critics on Wall Street, in foreign central banks, and in Congress screamed that its modest, $300 billion Treasury purchases were monetising the government deficit and paving the path for future inflation. They have added to the atmosphere of hostility now surrounding the Fed. The Fed has essentially decided to pursue a second-best (i.e. insufficiently aggressive) monetary policy because a first best monetary policy could bring political perdition.

The original article is linked here.

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Written by gregip

December 4, 2009 at 9:00 pm

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