How Much Ammo Does the Fed Have Left?

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Fed chairman Ben Bernanke needs your help. Bernanke is looking for a word that means longer than extended to tell people how long he plans to keep interest rates low. And what he is looking for is a word that means a really, really long time–really, really. Superextended. Overextended. Superduper-extended.

So this is what the economic science of central banking has become? A bunch of ivy league phds sitting around playing a high stakes game of Mad Libs. That’s one of the points Alan Blinder makes today in a very good editorial in the Wall Street Journal. Blinder’s editorial is about the fact that the Fed by lowering short-term interest rates to nearly zero, and expanding its balance sheet by buying Treasury bonds and mortgage bonds and other assets has already used its main tools of rejuvenating the economy. Now it has to take the nontraditional routes. Blinder runs through what those moves could be, and raises some doubts about whether any of them will be all that successful. But one of the potential moves Blinder points to looks very promising. Plus, here at the Curious Capitalist we are devoted to giving Bernanke every helping hand we can. He was, after all, our Main Squeeze last year. So he’s got that going for him. I don’t think the reality is as dire as Blinder paints for the Fed and its ability to further stimulate the economy. Here’s why:

It’s mainly because the Fed has one major policy lever at its finger tips, and it is one that Blinder points out.

In October 2008, the Fed acquired the power to pay interest on the balances that banks hold on reserve at the Fed. It has been using that power ever since, with the interest rate on reserves now at 25 basis points. Puny, yes, but not compared to the yields on Treasury bills, federal funds, or checking accounts. And at that puny interest rate, banks are voluntarily holding about $1 trillion of excess reserves.So the third easing option is to cut the interest rate on reserves in order to induce bankers to disgorge some of them. Unfortunately, going from 25 basis points to zero is not much. But why stop there? How about minus 25 basis points? That may sound crazy, but central bank balances can pay negative rates of interest. It’s happened.

This is the third policy option that Blinder mentions and even though he clearly thinks it is the best option for the Fed, Blinder still downplays it. And I am not sure why. I have wondered for a long time why the Fed continues to grant banks what is essentially interest on their risk-free savings accounts. When the Fed first started paying the interest on the bank reserves it hit me as a backdoor bailout for the banks, which made some sense at the time. But not now. Blinder says there is no guarantee that banks even if they were charged money to put reserves at the Fed would start lending. They may invest in other safe areas, like money market funds. Yes, but banks would only be happy with those low-interest rates for so long. They would eventually either loan out the money or put it into corporate bonds or municipal bonds, which lowers the cost of borrowing for others. What’s more, it’s not just banks that park money at the Fed. Foreign investors and other central banks do that too when they buy Treasuries. What about charging a fee to foreign investors who only buy US Treasuries? That might cause some of those investors to put their money more directly into our economy by buying corporate bonds, or even equities. Again, lowering the cost of capital for borrowers other than the Fed.

You could argue that pushing banks to lend money they don’t naturally want to could produce bad loans and send us right back to where we started. But Blinder’s own suggestion for what Bernanke could do, but he is not thinking about is this:

There is a fourth weapon, which the Fed chairman has not mentioned: easing up on healthy banks that are willing to make loans. Given bank examiners’ record of prior laxity, it is understandable that they have now turned into stern disciplinarians, scowling at any banker who makes a loan that might lose a nickel. That tough attitude keeps the banks safe, but it also starves the economy of credit.

That to me seems like a clearer path to bad loans. One we tried in the past decade and don’t want to try again. By removing the incentive for banks to do nothing with their money could produce some bad loans, it will probably produce a number of good ones as well, as long as bank examiners are on the job.

Lastly, there’s the part that you can help out with.

The FOMC has been telling us repeatedly since March 2009 that the federal-funds rate will remain between zero and 25 basis points “for an extended period.” This phrase is intended to nudge long rates lower by convincing markets that short rates will remain near zero for quite some time. The Fed’s second option for easing is to adopt new language that implies an even longer-lasting commitment to a near-zero funds rate. Frankly, I’m dubious there is much mileage here. What would the new language be? Hyperextended? Mr. Bernanke is a clever man; perhaps he can turn a better phrase.

Yes. The past year has shown that Bernanke is clever. But not nearly as you the clever as the readers and commenters on Curious Capitalist. So what say you? The suggestion box is open. What word means longer than extended?