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 you buy a one-year Treasury bill today, you know exactly how much money you’re going to have one year from now. On the other hand, if you buy a 10-year bond and sell it one year from now, you will have a capital gain if interest rates go down but a capital loss if interest rates go up. Because nobody knows for sure which is going to happen, you’re exposed to a risk with the longer term bond that you can avoid with the 1-year bill. Historically, holders of longer term securities received a higher yield on average as compensation for that risk.
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. All the Treasury has to do is stop issuing debt of maturity longer than one year, and do its new borrowing with short-term T-bills, to accomplish the same thing. That would lower the Treasury’s borrowing costs and stimulate the economy. 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. If the Treasury were more willing than private investors to absorb this risk, then yes, by doing so it might be able to lower long-term yields. But as a practical matter, the Treasury may be quite unwilling to absorb this extra risk.
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? I find it hard to come up with an answer to that question. The most natural perspective for me is that the Fed should be more risk averse rather than less risk averse than the Treasury.
It is true that price stability– avoiding excessive inflation or deflation– has traditionally and quite appropriately been regarded as the responsibility of the Fed rather than the Treasury. But I think the most important tools at the moment to prevent deflation would be exchange-rate targeting, fiscal stimulus, and direct credit extension, along with the possibility I’m discussing here of changing the maturity structure of publicly held government debt. And all of these would more naturally be directed by the White House rather than the Federal Reserve.
The one advantage I can see for the Fed in this regard is a political one. If the Treasury were to stop issuing long-term debt, it would lead to open public debate about whether this course represents prudent management of fiscal risk. If the Fed does what amounts to the same thing via open-market operations, the details are sufficiently arcane, and the Fed is a sufficiently independent institution, that directly elected public officials would not be the target of criticism for such operations. This in fact seems to have been an important reason why the Fed and not the Treasury was the chief actor in many of the initial policy responses to the financial crisis in the fall of 2008, even though those operations also had an essential fiscal as opposed to monetary component.
But that feature is precisely what makes me prefer to see such operations implemented by the Treasury rather than the Fed. I am a strong believer in democracy, warts and all, and am very leery of any effort to circumvent the process of legitimate democratic review and debate by those who fear the cumbersome process would derail their own superior designs.
In addition, there is the separate question of whether the exposure to additional interest-rate risk by the unified Fed/Treasury balance sheet would indeed continue to have the stabilizing effects suggested by the historical correlations if pushed to a starkly higher degree than anything in historical experience. The empirical estimates in our paper
simply took the risk characteristics of long-term bonds as given by their historically observed behavior, and assumed those wouldn’t change as the composition of publicly held debt changed. But it is certainly plausible that big changes in the Treasury’s or the Fed’s maturity profile might be regarded by some bond investors as themselves a new source of risk, separate from that in the observed historical data.
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.