Regular readers will recall that I have been very skeptical of claims that the Fed can cause a large reduction in unemployment by declaring a nominal GDP target and/or buying long term Treasuries. Joe Gagnon is very prominent advocate of unconventional policy, so I was surprised to find that I so strongly agreed with so much of what he wrote in this post. After the jump I will quote him and ask readers if the statements are familiar, because they are what I regularly write.
The Fed’s decision in September to sell short-term Treasuries and buy long-term Treasuries (known as Operation Twist) has put downward pressure on long-term interest rates. But, with the 10-year yield already down to about 2 percent, the scope for further reductions is somewhat limited. One percent is probably the effective lower bound on the 10-year Treasury yield.
Some have proposed that the Fed announce a desired path for the future price level (or future nominal GDP) that is higher than that currently expected by the markets. It is argued that such an announcement would raise inflation expectations, lower real interest rates, and stimulate economic activity. However, it is not clear that such an announcement, by itself, would have much effect. Indeed, during the past two years, there has been little tendency for market forecasts to move toward Fed forecasts. To increase its effectiveness, any such announcement should be accompanied by concrete actions to push market conditions in a supportive direction.
The best option available is a massive program of MBS purchases.
here are several reasons for the Fed to focus on the market for housing finance:
The market for agency MBS is one of the largest markets in which the Fed is allowed to operate. The Fed is not allowed to buy equity, real estate, or corporate debt.
MBS yields are the most important factor behind mortgage rates. As investors have flocked to the perceived safety and liquidity of Treasuries, the spread between mortgage rates and yields on 10-year Treasury notes has risen considerably. Fed purchases are especially effective at reducing those interest rates whose spreads to Treasuries are wider than normal.
Note two things. Gagnon stresses the importance of quality as well as quantity. He thinks it is important for the Fed to buy low quality assets. Also Gagnon is sticking to static supply and demand. He isn’t counting on expectations management.
Note that he cares about the covariances with say house prices of the assets the Fed buys not all stochastic assets add equally to the relevant risk. Finally note that the policy he advocates is the policy I have been advocating