Six Ways The Federal Reserve Could Boost The Economy

Our guest bloggers are Adam S. Hersh, an Economist at the Center for American Progress Action Fund, and Cameron DeHart, an intern at CAPAF.

Federal Reserve Chairman Ben Bernanke

The Federal Reserve, America’s central bank, has two jobs: make sure that inflation stays low, and make sure that employment stays high. Of late, with the economy still in a funk, the Fed’s first job has been easy to manage; the second, much less so.

Today and tomorrow, Federal Reserve Chairman Ben Bernanke will testify before the House Financial Services Committee and the Senate Banking Committee. While the private sector continues adding new jobs — each month for the past 28 months — unemployment in the United States remains unacceptably high four and a half years since the start of the Great Recession. At fulfilling its employment mandate, the Federal Reserve is failing.

Since the crisis began, the Fed has taken some out-of-the-ordinary measures to help boost employment, but can it do more? The answer is undoubtedly yes. And members should ask Bernanke why he and the Fed are not taking these or other actions to do its job consist with the severity of America’s unemployment woes:

1) Target the economy, not inflation. Currently, the Fed targets its policy to maintain a 2 percent annual inflation rate (currently running at 1.7 percent annually). The market knows this and tempers its investment behavior accordingly. Instead, the Fed could target the growth of gross domestic product, before inflation, so-called “nominal GDP targeting.” This would amount to a pledge to keep our economy growing on a sensible path, according to University of California, Berkeley economist Christina Romer. The move would work by causing investors and consumers to form expectations of slightly higher inflation, thereby creating an incentive to invest and consume today instead of tomorrow.

2) Target unemployment. Charles Evans, the President of the Reserve Bank of Chicago, suggested adopting an explicit target for the unemployment rate, following a so-called “Evans’ Rule.” In line with its dual mandate of stable prices and maximum employment, the Fed should pledge to do whatever it can to get the economy back to full employment, even if that means accepting a little more inflation for the time being. There is no reason to think accepting slightly higher inflation for lower unemployment is any worse than accepting higher unemployment for low inflation—and a lot of reason and economic evidence to suggest it is much better.

3) More easing. The Fed has already engaged in two rounds of “quantitative easing” — directly buying assets in financial markets to affect interest rates. Now it’s time for a third. Past easing primarily targeted government bonds, whose rates underpin our financial system, and mortgage-backed securities. But there’s no reason the Fed needs to stop there. The next round of easing could also target municipal bonds, student loans, or even securitized credit card assets to push down interest rates on infrastructure investments for cash-strapped state and local governments, for education that help people boost their skills and temporarily take sabbatical from the labor force, and for financially-strained families.

4) Keep on twistin’. In September 2011, the Fed introduced “Operation Twist”—aiming to tweak earlier quantitative measures in order to push down longer-term interest rates. While not changing the money supply, the move “twists” the Fed’s holdings to sell short-term securities and buy long-term ones. Since that time, 30 year interest rates have fallen nearly one percentage point, helping to push down interest rates on, among other things, mortgages for new home purchases and refinances. The Fed could twist some more to give greater confidence and incentive to people looking to invest in America for the long-term.

5) Take big banks off the dole. At present, the Fed pays private banks 0.25 percent interest on funds deposited with the Fed in excess of what is required for prudential purposes. That’s more than the interest rate banks can earn by lending to low-risk real businesses, about 0.14 percent at present. Currently, banks hold more than $1 trillion in such excess reserves. By keeping excess reserve interest rates so high, not only is the Fed subsidizing the profits of big banks, but also it is not creating incentives for banks to do the work of lending. Cutting off excess reserve interest payments — or better yet, charging negative interest penalty on reserves in excess of prudential requirements — will give banks an incentive to lend and make them work for their big profits.

6) Dollarize the recovery. The Fed’s actions to boost employment in the U.S. economy need not focus on our own financial markets. Rather, the Fed can wield its power to create money against the artificially undervalued currencies of other countries, like China. By intervening to sell dollars for targeted foreign currencies, the Fed would create pressures to rebalance exchange rates, thereby improving the global competitiveness of American exporters and domestic producers and leading directly to a strengthening of the U.S. economy and job creation.

For his part, Bernanke should step up to the bully pulpit and press Congress on why it is not doing more to address America’s unemployment crisis. Though the Fed still holds a lot of arrows in its quiver, Bernanke surely knows that straightforward fiscal policy could easily outperform a monetary policy bank-shot in job-creating bang for the buck. That’s why he should use the Fed’s economics acumen to push back on conservatives in Congress whose zeal for spending contraction is pulling the rug out from under us even as the Fed tries to shift the economy into a higher gear.