Thursday, October 7, 2010

Back to the Future? Fed weighs a more focused response

Earlier this week I talked about Federal Reserve policy in the first part of the twentieth century.

Up until 1951, one of the main tasks given to the Fed was to target interest rates on U.S. government debt. It was thought the our government should never have to pay more than 2.5% on bond obligations. And so, by law, Congress told the Fed to intervene in the bond markets whenever interest rates threatened to move higher.

Now it appears that there is serious discussion in Washington to resume this policy, although this time it would be to try to stimulate economic growth.

According to The Washington Post:

...Instead of just announcing that it will create, say, $500 billion out of thin air and buy bonds with the money, the Fed could instead announce it will target a certain interest rate and then buy Treasury bonds so that rates in the marketplace reach that level.

For example, the Fed could announce that it aims for three-year Treasury debt that now carries an interest rate of 0.56 percent to instead be 0.25 percent. It would then buy Treasury notes in whatever amounts were needed to get rates to the target level.

That would help the economy by lowering rates for a broad range of borrowers, including Americans looking to take out a mortgage and companies looking to use debt to finance expansion. It is a strategy that Fed Chairman Ben S. Bernanke endorsed in a 2002 speech, when he was a governor at the Fed, explaining policies the central bank could take to make sure the United States does not fall into Japanese-style deflation.

Fed weighs a more focused response

I'm not sure I know all of the economic implications of this policy would be, but it certainly is a sign that Bernanke is thinking about less conventional methods to try to get our economy going. However, I suspect that if the Fed is going to be actively buying Treasurys, interest rates will probably be moving lower.