What more can the Fed do ?

This post is long, vague, sloppy and after the jump. The one sentence version is that the Fed can affect the real economy by buying assets which private investors consider risky.

Before discussing useful things which I think the Fed can do to stimulate the economy, I will explain at length why I think that some proposed interventions would not be effective. I won’t argue this (here or in comments) but I think that last years massive purchases of treasury securities (aka QE2) had very little effect on anything.

One possible future policy would be much more of the same, that is much larger purchases of long term treasuries with Fed liabilities. The academic discussion of possible QE2 started with a proposal of $ 5 trillion new Fed liabilities issued. The actual QE2 as announced was one tenth that much. I don’t think that much huger operations would have a very large affect on anything that matters. I think this for two reasons.

First the return on long term bonds with negligible default risk is the compounded expected return on short term bonds plus a risk premium. Here the risk is not default risk but the risk of mark to market losses over a short horizon due to higher than expected future short term rates. A change in the amount that private investors must hold reduces the risk premium. The private sector as a whole can go short Treasuries (only the Treasury can do that) so the risk premium can’t be driven below zero. It appears to be very low right now, since the overall interest rate yield on Treasuries is low and presumably short term rates will return to normal some time in the next 10 years.

Second the interest rate that matters for private sector fixed capital investment is the cost of capital to firms, not the cost to the Treasury. Here I think an important problem might be the cost of capital to firms with poor bond ratings, but the risk premium they pay is mostly due to default risk and not at all the same as the risk in long term Treasuries (I’d guess it is negatively correlated — good GDP growth means higher interest rates on short term Treasuries and low risk of default by firms — long term Treasuries are insurance against poor growth — less of them in private hands should, in my view, increase the cost of capital to firms at risk of bankruptcy).

Third, while firms care about interest rates over years, I suspect that managers have enough of a short term bias that the rate that matters is over 5 years or less (in a pinch 7 years or less). The expected flow of funds seven to thirty years from now is just not likely to influence their decisions. These interest rates are already very low and can’t be negative.

I don’t think the Fed can drive down short term nominal rates expected for many years from now with QE3 or announcements about plans for the future or in any way at all. They depend on future monetary policy by future Fed Open Market Committees facing future conditions.

The interest rate that matters for firms deciding on investment should be the real interest rate. I also don’t think that the Fed can drive up inflation expected for many years from now for the same reason. A higher declared inflation target should only affect inflation expected for the near future if the Fed will have some way of affecting inflation in the near future. It shouldn’t affect inflation expected for when the economy is back to normal — a promise to create inflation in the distant future by driving unemployment below the NAIRU is not credible.

So I don’t think that much more of the same will affect GDP much.

How about helicopter drops of money ? If the Fed gave away money rather than loaning it or buying financial instruments, then it would create the illusion of wealth. However, the Fed can’t do this. The helicopter drop story is a teaching example. Giving money away is fiscal policy. This isn’t just a semantic point — Congress can’t give any other body the authority to give away US Federal money — this is clearly written in the constitution. Furthermore the argument that the Fed should give away money is based on the argument that Congress should but won’t. Doing something that only Congress may do, because Congress won’t do it, is plainly unconstitutional. Also I’d guess someone (Ron Paul or a Paulican) would sue. The Republican party is against this, so I guess that the Supreme court would block it.

I think it is already clear what I think the Fed can do which would be useful. First I think the economy would be stimulated if someone bought a whole lot of junk bonds driving up their price and driving down the cost of capital to firms with poor bond ratings. The creation of Maiden Lane, Maiden Lane II and Maiden Lane III ltds makes it clear that the Fed thinks it can’t do this directly. So I propose loaning more money to one of them (or setting up Maiden Lane IV) and having that entity buy a lot of junk bonds.

These are the assets whose price is most likely to affect investment. They are assets which are considered risky so their return can be much reduced if private investors are required to hold less of them.

Other risky assets are, of course, mortgage based securities. The Fed can and has purchoased rmbs issued by government agencies. Here I tend to guess that the Fed can renegotiate servicing contracts to make foreclosure costly to loan servicers. I even think the Fed can renegotiate mortgages with debtors (OK I hope it would be allowed to do this if it tried). In any case, it can definitely agree with firms servicing its mortgages that they are not punished for forgiving debt which will never be paid or rewarded for foreclosing on houses which they then can’t sell.
As beneficial owner, the Fed is the principal. It must be able to prevent its agents from acting against its interests.

So I think that the Fed can act as owner of mortgage backed securities to renegotiate absurd incentive contracts and can (indirectly) buy junk bonds.

So why isn’t anyone talking about these possibilities ?