Fed weighs a more focused response

By Neil Irwin
Washington Post Staff Writer
Wednesday, October 6, 2010; 11:53 PM

As the Federal Reserve considers what steps it might take to try to boost growth, attention has focused on whether the Fed might buy an enormous quantity of bonds to flood the economy with some specific amount of money.

But there's another option that economists at the central bank are examining that has attracted little notice. 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.

Describing such a strategy as "more direct" than other options, and one "which I personally prefer," Bernanke said in 2002 that the Fed could "begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields."

And, Bernanke added, "if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years."

There is clear momentum among top Fed officials for taking new action to strengthen economic growth, perhaps at their Nov. 2-3 meeting. But with the Fed's usual tool for managing the economy - its target for short-term interest rates - already near zero, there is wide uncertainty about the exact form such new steps would take. Top policymakers at the central bank - and the many economists on staff - are spending much of their time analyzing those options.

In 2009, the Fed supported the economy by announcing $1.75 trillion of asset purchases to expand the money supply, then carried out those purchases over time; the Fed could do something similar again. A second approach that has gained favor recently would be to announce a much smaller volume of purchases, then revisit the question at each Fed policymaking meeting, gaining the flexibility to respond to evolving economic conditions.

The third option, of setting a target interest rate for Treasury securities, would have both costs and benefits relative to those possibilities.

One of the benefits is that simply announcing a formal interest rate target could lead rates to rapidly converge on the Fed's goal simply through private market forces. If that happens, the Fed may not need to print as much new money to get the same economic boost as if it used other methods. Moreover, targeting two- or three-year interest rates could be seen as a logical continuation of the Fed's normal tool for managing the economy, which is to target short-term interest rates.

"It would get them back to something more like normal operating procedure, where they target a rate rather than a certain number of hundreds of billions of dollars," said Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics and former Fed economist who advocates that the central bank set a target interest rate of 0.25 percent for four-year Treasury debt.

But there are costs as well. For one thing, depending on how markets react, the Fed could end up having to deploy vast sums of money to achieve its target rate, which would make it harder to exit from the policy down the road when the economy is on stronger footing.

Moreover, while the Fed and other central banks have experience announcing planned bond purchases and setting targets for overnight lending rates, targeting longer-term interest rates is an untested strategy that could have hard-to-predict consequences.

"We're in the experimental drug phase of monetary policy," said John Makin, a resident scholar at the American Enterprise Institute. "These are all very nice ideas, but there's no real experience to tell you what works best."

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