Fed Chairman Ben S. Bernanke. (TAMI CHAPPELL/REUTERS)

Ezra Klein: Later today, the Federal Reserve will release a statement that is expected to detail its next steps forward. What should it say?

Joe Gagnon: They should do a major QE3. It’s long overdue at this point. I think QE2 was just way too small to matter. You need big numbers in these things. It’s not like spending. It’s a swap of two different types of assets. So the effect is much, much smaller than if you were spending the same amount of money. So I would start with $2 trillion and say that we have an unlimited capacity to do this and we will do however much is necessary to get the economy moving. Build the expectation that this is just a downpayment. This is the problem the Bank of Japan had, where every time they did something, they immediately said this is the most we can do and we can’t wait to stop doing it. You want to be bold and say this is not our last bullet and we can and will do more if we need to.

And they should talk about what they want to happen. They should want to get mortgage rates, down, they should want to get the dollar down, get corporate bond yields down. Everyone in the country should now have a four-percent mortgage. This is the way to get at the Carmen Reinhart/Ken Rogoff problem, which is that people are overleveraged. By reducing their monthly payments, you reduce their debt burden and help them spend. That, alongside exports, is the key.

EK: So what assets should the Federal Reserve buy to achieve all this?

JG: I would expand it beyond Treasuries. They need to really fix the mortgage market. So long-term Treasuries. Agency-MBS. Maybe foreign exchange.

EK: Let’s just define some of that. Agency-MBS are mortgage bonds guaranteed by Fannie and Freddie, right? And foreign exchange means buying up the currency of other countries. Why do you want them to do that?

JG: It’s buying the bonds of other countries. It’s a bit problematic, to be clear, because of the whole currency wars thing. But other countries do it to us. China is doing it to a massive and unprecedented extent. Ideally, we would neutralize their purchases by buying their bonds. But they won’t let us. So that’s the problem. Whose bonds do you buy? If we buy Europe’s bonds, we could be seen as bailing out Greece. But the point is to send the message that the strong-dollar policy is over because we need to strengthen exports. So I would buy bonds from Japan and Germany and Singapore and Korea.

EK: And what’s stopping them? When you explain this, it all makes perfect sense. But Bernanke has consistently shied away from intervening on this scale. What is he afraid of?

JG: Two things. First, they saw the core inflation rate rise this spring. On a three-month basis it was 2.5 percent, though it now seems to be headed back down. That put them on their guard,. Now, they do need to worry about inflation. But I would say three percent is where I would get nervous, not two percent. So I would be bolder there. The other thing is their balance sheet is big and getting bigger and that exposes them to risks. They’re making profits hand-over-fist right now, but they could have losses at some point in the future and that might look bad. They could goof and not unwind their purchases fast enough. They’re really like sailors without a chart at this point. We’ve never been here before and that makes them nervous. But caution has its own risks.

EK: One criticism you hear of the Obama administration is that there are two open seats on the Fed board. If the White House had filled those seats would things be significantly different today?

JG: Well, if they had put me and someone else on the board and we would be out there dissenting on the other side from the inflation hawks, but I’m not sure we could have swayed much policy. I don’t know that two votes is decisive. People overstate the influence of the hawks. They are a permanent minority. They’re really off on their own. There is a core of centrists that Bernanke could lead wherever he wants.

EK: On the same subject, what would their role be in the policy you lay out? The Federal Reserve can bring mortgage rates down, but that doesn’t repair the housing market on its own. It creates an opportunity for the administration to do more to repair it, right?

JG: The Fed should create an opportunity and the Obama administration should take advantage of it. The Obama administration has the power to really extend the universe of homeowners who can take advantage of lower rates. Fannie and Freddie announced programs over the last two years saying if you already have a guaranteed mortgage, even if you would not normally be able to refinance, now you could. But they put on too many conditions. They said you needed to use your normal servicer, for instance. They also made Fannie Mae and Freddie Mac raise their standards on borrowers, which is scaring the banks.

They need to break those restrictions. I agree that new borrowers should require downpayments and so forth. But if you have an existing loan, it’s a win-win for the government to help you refinance, because if you can refinance, you’re less likely to default. There is a loser here, but it’s China and rich investors who hold these loans. And why should we be protecting them?