Will the Fed Rescue the Economy?
The Federal Reserve Board’s Open Market Committee (FOMC) meeting this week likely presents its last opportunity to boost the economy before the end of the year. While the FOMC meets every six weeks, as a practical matter the FOMC has historically been very reluctant to take major moves close to an election. After this week’s meeting we will be in the window where the Fed is unlikely to move. This means that it is especially important that the Fed take steps to boost the economy now.
The fact that the economy can use an additional boost should not be in dispute. The rate of job creation in the last two months understates the underlying growth path since it is essentially a payback from the stronger growth due to an unusually mild winter.
Even the 165,000 average rate of job creation for the last five months is far too slow. With the economy needing roughly 100,000 new jobs a month to keep pace with labor force growth, it would take us more than 12 years to make up our 10 million jobs deficit at this point.
If there is a clear need for more rapid growth, the data also show there is no downside risk of excessive inflation. The consumer price index fell 0.3 percent in May. It has risen by just 1.7 over the last year. The core index rose 0.2 percent last month and is up 2.3 percent over the last year.
Of course many of us have argued that higher-than-normal inflation would be desirable in any case. It would reduce real interest rates in a world the Fed has already pushed the nominal Federal Funds rate as low as it possible can. That would provide businesses with more incentive to invest. Higher inflation should also help to lift house prices, helping homeowners to rebuild equity.
However even if the Fed is unwilling to accept the idea that it should promote higher inflation, as Chairman Bernanke had recommended back in his days as economics professor, it should at least be confident that the data show no reason to be concerned about inflation exceeding its target.
In this context the Fed should be prepared to take additional steps to boost the economy. There are two routes the Fed can go. First it could do yet another round of quantitative easing. This amounts to buying up more long-term debt, either Treasury bonds or mortgage-backed securities, with the hope of driving down long-term rates further.
The Fed already owns close to $3 trillion in mostly long-term debt. It could buy another $1 trillion or so in the hope of putting somewhat more downward pressure on long-term rates. In an optimistic scenario, perhaps this would lower the 10-year Treasury rate by 15-20 basis points. That would allow for some additional mortgage refinancing and perhaps be a modest spur to investment. It would also help to lower the value of the dollar, which would increase our net exports; although the improvement on the trade balance will likely take six months to a year to be felt.
The alternative route would be to pick up an idea that Bernanke tossed out three years ago. He could target a longer term rate. For example, he could announce that he would set a target of 1.2 percent for 10-year Treasury bonds for the next year (compared with around 1.5 percent at present). This would mean that the Fed would buy as many Treasury bonds as necessary to bring yields down to this level.
This would have a similar, but likely somewhat more powerful effect as another round of quantitative easing. In an optimistic scenario it could lower 30-year mortgage rates by 20-30 basis points, allowing for a somewhat bigger impact on mortgage refinancing and investment.
In neither case will the Fed action turn around the economy. The refinancing process itself will create jobs and provide some boost to the economy. In an optimistic scenario Fed action could spur 5-10 million refinanced mortgages over the course of a year. If we assume an average saving of 1.5 percentage points on a $180,000 mortgage, this frees up $13.5 billion to $27.0 billion in mortgage payments to be spent on other items. That is between 0.1 and 0.2 percent of GDP. That might translate into 200,000 to 400,000 jobs. That’s not getting us to full employment, but it is a step in the right direction.
There is one other important aspect to the Fed’s actions that is almost never mentioned. The interest that the Fed earns on its assets is refunded to the Treasury. Last year the Fed refunded almost $80 billion in interest to the Treasury from the bonds and mortgage-backed securities it held.
If the Fed buys more assets, it will have more interest earnings to refund to the Treasury. This is not the main reason that the Fed should act, but given the obsession in Washington over debt and deficits, larger interest earnings from the Fed have to be just about the most painless way to lower the deficit. If we can stem the urge to cut funding for education or Medicaid by having the Fed buy a few hundred billion more in assets, that would be a pretty good reason to do it.