Reading notes on Bernanke’s roadmap speech

Next week is an important week for the US economy. The Fed has probably its last opportunity to make bold announcements before staying mum for the presidential election. This is why it’s important to re-read the speech Bernanke made about fighting deflation years ago, which many see as the roadmap followed by the Fed Chairman in combating deflation in the US.

My conclusion at this point is that the Fed is likely to not commit on a quantity of money (as it did in “Quantitative Easing 1″ and 2) but focus on an inflation or interest rate target, leaving open the quantity and type of assets it will buy to achieve that goal. This is what will give them the most flexibility over the next year as the election unfolds. This is what analysts have referred as “interest rate caps“.

Of course, I’m highly skeptical of the actual benefits of this action for the real economy, unless it can be focused on assets that will create local jobs and restore confidence in the future, and unless it can limit the abuse of free money. But this would be quasi-fiscal policy. I also think that the Fed is experiencing diminishing returns on their actions (QE2 was less effective than QE1 from a Main Street economy standpoint), and their credibility in actually fighting deflation may start to be put into question by markets.

Noteworthy excerpts of the speech below.

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities.9 There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time–if it were credible–would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to 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. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly.12 However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window.13 Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral.

The following is interesting in the context of the recently announced collaboration between central banks to address the US dollar demand of European banks. Of course, the plan announced by the Fed is unlikely to be specifically linked to this, since this type of operation is politically difficult.

The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.

This part is interesting in the context of Jobs plan that Obama recently announced. But the plan is unlikely to be in effect in time for the Fed to play its role, if it is voted at all, so it’s unlikely that the Fed actions will be directly linked to it.

the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices.


Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.

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