James Hamilton and Cynthia Wu on Non-Standard Monetary Policy
Jim writes:
Should the Fed try to depress long-term yields further?: I've been sharing with readers my recent research with Cynthia Wu, in which we found that the Fed could likely lower long-term interest rates further by buying more long-term securities, even though the short-term rate is essentially zero and even though the newly created reserves would simply sit idle in banks' accounts with the Fed. Here I'd like to take up the question of whether such a policy would be desirable.
According to the framework proposed in our paper, the essential characteristic that allows nonstandard open market operations to be able to influence relative yields is the fact that long-term government debt has different risk characteristics from short-term debt.... If the Fed were to buy a large enough volume of long-term debt, it might be able to reduce the net risk exposure of the private sector so as to change slightly that average compensation and flatten the slope of the yield curve. Whether that's indeed possible, and how big a change in rates we might expect to see, is an empirical question. What Cynthia and I found, based on what was observed on average over 1990-2007 in response to modest changes in the maturity composition of publicly held Treasury debt, is that replacing $400 billion in outstanding long-term Treasury debt with short-term debt might lower the 10-year yield by 14 basis points. Our estimates also imply that, in the current environment when short-term rates are essentially zero, if the Fed were to buy about $400 billion in long-term Treasury debt outright with reserves newly created for that purpose, it might still be able to reduce the 10-year yield by about 14 basis points.
The first point I'd like to emphasize is that, although I described the operation above as something implemented by the Federal Reserve, it's really much more natural to think of as something for the Treasury to do.... So why wouldn't the Treasury want to do such a wonderful thing? The answer seems pretty obvious. The reason the Treasury has never relied exclusively on short-term borrowing, and the reason it wouldn't be willing to today either, is because if all its debt were short term and interest rates subsequently go up, the Treasury could be faced with a ballooning refinancing problem that could be very hard for it to fill. The Treasury doesn't want to face the risk of higher interest rates any more than private investors do.... And if we suppose that the Treasury has good reasons to try to avoid exposure to this risk, what sense could it make for the Fed to absorb the risk on behalf of the Treasury?...
Here's where I come down. If we do see more disinflation and further deterioration of economic conditions, I think the Fed has no choice but to try to use its powers to pursue its mandate of promoting maximal employment and stable prices. My guess is that additional purchases by the Fed of long-term assets will be a necessary part of that.
But even though the Fed still has some ammo left, this particular gun is one that I believe they should fire with reluctance.
