My favorite U.C. Berkeley economist, J. Bradford Delong, reflects on the New York Times’ Paul Krugman’s description of further quantitative easing by the Federal Reserve Bank. The article helped clarify two recent conundrums that have puzzled me, yet were not sufficiently sensationalized to motivate me to actively research on my own.
Question: How can the Fed enact any further monetary policy if the Fed Funds Rate is approaching 0%? I thought that zero was an absolute lower boundary for interest rates.
Answer: Further quantitative easing describes the U.S. government’s plan to shorten the maturity of its outstanding debt in order to push down long-term interest rates. How so? By paying off long-term obligations with short-term borrowing.
This is the Fed’s balance sheet:
Liabilities = Monetary Base = Currency in circulation + bank reserves
Reserves are like short-term borrowing, sort of analogous to commercial paper on the corporate side. The Fed pays a tiny interest rate on reserves, comparable to T-bill rates (less than 1%). Currency in circulation a.k.a. cash, is another liability that pays no interest.
When the Fed buys long-term government securities, federal debt is taken off the market, and paid for by issuing more short-term debt (which increases the monetary base). Effectively, the Treasury would be selling 3-month T-bills and buying notes and long bonds with the proceeds. Both M1 and M2 would increase. This sounds very much like the overwrought cliche of using the Treasury to print more money. The consequence is devalued currency and inflation! Bear with me yet a moment longer, please.
Delong’s rationale for quantitative easing is
to reduce the interest rate that matters for private business investment: the long-term, default-risky, systemic-risky, beta-risky, real interest rates at which businesses finance their capital expenditures.
Delong suggests that the flow-of-funds rate can be lowered, and economic activity increased, by reducing the “safe” real interest rate on short-term government debt, or reducing the various premia–duration, default, systemic risk, and beta risk–between the rate the U.S. Treasury pays to borrow (T-bill interest) and the rate businesses pay to borrow.
FOMC activity lowers T-bill rates and addresses the first of the two points. Once the nominal T-bill rate is at zero, quantitative easing policies will create expectations of higher future inflation. However, my concern expressed above regarding inflation is unwarranted. Yes, there will be inflation. However, this is a desirable outcome, and crucial to quantitative easing, as it will result in lower real interest rates on T-bills, helping the situation.
Delong then confronts that pesky matter of zero interest rates as a lower boundary. He too comes to the conclusion that once the nominal T-bill rate is zero, monetary policy (in this case, heightened inflationary expectations) can no longer be impacted with tools available to the Fed, and quantitative easing cannot be sustained. He suggests an approach that I consider a rather radical form of quantitative easing, as it would require the Federal Reserve Bank to act beyond its usual sphere of influence. Actually, that’s an understatement!
Please note, Delong does not advocate the following actions, but tosses the idea out as a possible approach in dire circumstances:
…quantitative easing [could] involve Federal Reserve purchases of long-term risky private assets rather than merely long-term U.S. Treasuries. Hiring PIMCO as an agent to manage a long bond index portfolio comes to mind–if one could avoid its front-running… the most effective quantitative easing program of all would involve the Federal Reserve issuing reserve deposits [to purchase assets] that are the furthest away in their risk characteristics from short-term government bonds: bridges, dams, the human capital of American citizens, police protection, research and development. The best quantitative easing program of all is a money-financed fiscal stimulus, as Jacob Viner said back in 1933:
“… the federal government and the Federal Reserve system … made mild motions in the direction of inflation, which did not succeed in achieving it…. [If] a deliberate policy of inflation should be adopted, the simplest and least objectionable procedure would be for the federal government to increase its expenditures or to decrease its taxes, and to finance the resultant excess of expenditures over tax revenues either by the issue of legal tender greenbacks or by borrowing from the banks…”