A new study in which I participated has been posted on the website of the Federal Reserve Bank of New York. It documents how the Federal Reserve lowered long-term interest rates about 50 to 60 basis points last year through its purchases of $1.7 trillion of longer-term bonds. The study reinforces an argument I have previously made: The Federal Reserve and other central banks can apply further monetary stimulus by lowering long-term borrowing costs even when short-term interest rates are stuck at zero.
And then the should:
With unemployment projected to remain far above most estimates of its equilibrium for the next few years and with core inflation having fallen to 1 percent over the past 6 months, the US economy clearly needs more of this medicine. As I argued last December, the Fed could push down long-term yields another 75 basis points by buying a further $2 trillion of long-term bonds. Current yields on 10-year Treasury notes, at 3.7 percent, are far above the zero rates on short-term Treasury bills. The benefits to the economy would be rapid and similar to those already observed from the first round of Fed purchases. Moreover, lower long-term interest rates and a faster recovery would also reduce our national debt.
Does additional Fed action mean that inflation is going to come roaring back? Not unless the Fed forgets everything it learned from the 1970s. But right now, inflation is below the Fed’s target of 2 percent and heading lower. The immediate problem is deflation. As Japan shows, acting too weakly against deflation is a serious error. Yes, the Fed may have to reverse course in a couple years, but that would be better than facing a decade of excess unemployment and entrenched deflation.
It’s true that there are risks of going down Gagnon’s path. But the current path guarantees years of mass suffering for the unemployed and trillions in lost output. And it carries the risk that if some new bad thing hits, we’ll be pushed into a deflationary spiral. The Fed can avoid this outcome, and the Obama administration can help the Fed avoid this outcome by appointing some expansion-minded people to fill the vacancies on the Board of Governors. I think this Joe Gagnon guy might be a good candidate. It’s good that congress is approving some additional stimulus measures, but they’re small beer compared to the size of what’s needed.