What Should the US Federal Reserve Do?


With the US on the brink of a relapse into recession or, at best, a period of very slow growth and rising unemployment, all eyes are on the Federal Reserve. After all, it seems to be the only show in town. The conventional wisdom is that there will be no second round of fiscal stimulus forthcoming from the US Congress anytime soon – unless you count the weakest possible stimulus which would be an extension of the Bush tax cuts for the rich. Republicans will veto any major round of public investment, and there is no sign that the Rubinomics team will shift in that direction in the brief time they have left before the Congressional elections to shift the economic policy agenda. 

So that leaves monetary policy. There seems to be an emerging consensus that a new round of quantitiative easing should begin- see for example FT columnist and US correspondent Clive Crook in today’s FT who Krugman claims as an ally in his blog. But what kind of easing should progressives support?

 My old friend Tom Palley has weighed in on the subject in the FT. 

 I was more than a little surprised to see that he calls for a modest increase in interest rates, albeit combined with further Fed purchases of financial assets via renewed quantitative easing. 

I tend to agree with his point that extended ultra low interest rates risk inflating new asset bubbles.

“Raising interest rates in this fashion would also diminish tendencies towards speculation and excessive risk taking. Prolonged very low interest rate environments encourage yield chasing that over-inflates asset prices, and this process often ends in tears.

By chasing yield, households stand to suffer large losses should policy succeed in guiding the economy out of recession, thereby triggering higher interest rates. This risks a vicious double blow to households whose savings and pensions have already suffered from the financial crisis. Moreover, poorer, less financially sophisticated households are likely to suffer most from rising interest rates as the searing effects of the crisis have tilted money flows toward safe investments such as Treasury bonds. Banks are also at risk to the extent they have been parking excess reserves in longer bonds to exploit the slope of the term structure of interest rates.”


He has a point here.  But surely the key point should be that we need expansionary fiscal policy. If we are not going to get it, then do we really want higher interest rates? I think not.

 Palley calls for a new round of purchases of mortgages securities to help revive the moribund US housing market which may make sense, especially for distressed home owners.  It does, however, seem unlikely that we are going to get much impact on the real economy as the housing bubble works its way out.

He adds sensibly that:

“Purchases of state government bonds would lower financing costs for states at a time of large state budget deficits. That could help avoid cutbacks to state and local government employment.”

I was, however,  surpised that he goes on to call for an end to Fed purchases of long term federal bonds, on the rather dubious grounds that higher incomes from higher interest rates would boost consumption.

“Moreover, government interest payments are an income transfer to the private sector, a form of tax rebate. Consequently, increased interest income on government bonds would stimulate consumption spending, especially among households (such as retirees) that rely on such income.

The same logic holds for raising the federal funds rate. This would raise money market and deposit account interest rates, thereby helping savers. To the extent that such financial assets are disproportionately held by lower income households and retirees who spend most of their income, this would boost their income and consumption spending.”

Since when were interest bearing assests disproportionately held by the lower end of the income spectrum, as opposed to pension funds and other large institutional investors?

It strikes me that even though US long term bonds are at historic lows, it remains important for the Federal Reserve to maintain the space for a renewed round of fiscal stimulus. Borrowing costs for the US government are currently so low that a longer term public investment program which could have a major impact on jobs and on growth could be readily financed and increase potential growth moving forwards.

The bottom line is that I am dubious that quantiatitive easing can avert a double dip alone, Rathe, expansionary fiscal policy is the only effective means to ensure that quantitiative easing actually expands real demand in the economy.  The US needs both ultra low interest rates and an active fiscal policy rather than the unwinding of the current anaemic stimulus package which is expiring. 

I fear that even US progressives are starting too place too much faith in what monetary policy can do.


  • In your second-last paragraph, I think his point may have been that bank-deposit products tend to be a higher percentage of the assets held by lower-income people, with higher-income people more likely to hold equities and bonds (mainly through mutual funds), but I could be wrong.

  • I tweaked the post which changes the para number. I doubt that a significant share of government bonds or even GICs are held by lower income retail investors, though they would indeed hold an even smaller share of equities.

  • 30 years of monetarism is various guises will make even progressives look to monetary policy. Krugman has been very good on this. I agree with him that the Obama should back door fiscal stimulus via the Macs and give a haircut to mortgage debt. The market is effectively doing that right now but it is through a cumbersome legal regime that is far too slow to be meaningfully stimulative. If one good thing eventually comes out of all this it will be the death of the idea that monetary policy is more potent and less dangerous than fiscal policy.

  • An old conversation, on this very issue.

    (Comment from Brandon L
    Time: November 28, 2009, 3:05 pm
    I can get the link from this site)

    ““Just wait, the housing crisis will again rear is head in the USA, and then what, more trillion dollar bailouts? I think not, we are heading for the mother of all crashes- and yes the sky is falling.” – Paul Tulloch

    This remains to be seen I do not think the FED will stand their and watch the industries it just bailed out, wither and collapse, under the renewed housing crisis. It will inject and inject and we will never see 800, or 900 lows on the S&P ever again.

    Too many mortgage holders vote, and are you ready for quasi-trillion dollar bailouts you ready for that? and Yes the sky is falling in year or two or more years from now when everyone looks to the FED to raise rates and they dont because of onging problems in the housing sector and labor markets and low inflation(cough) will warrant exceptionally low rates for an extended period“

    We will never have savings to spend on consumption without finacial reward to save. Interest rates cant be lowered anymore, unless you want a negative real interest rate. Higher Interst rates would help very much in distrubuting where the credit should go, small business. Which in my grandmothers day, happened with higher rates of interest.

    My grandma spent her interst from her savings, when she could responsibly, for her kids etc.

    People will realize that savings out of illusory asset price gains, like stocks and real estate, are not permanent income; and therefore, if we want to have money for retirement, we have to save money from current income; which can never ever ever happen with artificially low rates. Rising rates, and that has, of course, a negative short-term impact on the economy.

  • Hi Andrew, I think your most important observation is your last line.

    We need to start hearing about a whole lot more options than what are being considered. Potentially 4-5 month of more financial stumbling and the resulting economic hammers beating on workers we might actually see some new solutions enter into the current debate. Very limited vision being used right now.

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