Ben Bernanke never seems to be at a loss for ideas. The former Federal Reserve Board chairman who introduced a massive program of quantitative easing in the U.S. during the Great Recession has just written a new blog suggesting another potential, novel strategy the Fed could use to address the next slowdown – targeting longer term interest rates. (The latest blog is the second in a two-part series; the first installment focused on negative interest rates.)
At the outset, Bernanke admits that “it is unlikely that exotic policy tools like negative rates or targeting longer-term interest rates will be used in the U.S. in the foreseeable future” but notes that just talking about them can influence investors’ expectations. That, in turn, can alter markets, and paradoxically make it easier for the Fed to achieve policy goals or targets without ever taking the suggested action.
“Educating the public and market participants about more-radical monetary policy alternatives might help ensure that those alternatives are never needed,” writes Bernanke.
Some Perspective on the Fed’s Toolbox
Before recounting what Bernanke is suggesting in his latest blog, it’s important to remember what the Fed has done up until now to revive a faltering economy. Its most common tool is to lower short-term interest rates, specifically the federal funds rate, which is the rate banks charge each other for overnight loans. The current Fed Funds rate is 0.25% to 0.50%, up from a range of zero to 0.25%, which prevailed for seven years, until December.
But during the financial crisis, the Fed also initiated a policy of quantitative easing for the first time, buying huge quantities of long-term Treasury bonds and mortgage-backed securities in order to lower long-term rates and therefore boost borrowing on the part of consumers and businesses. The Fed ended those purchases in late 2014 but continues to roll over maturing debt so its balance sheet remains near $4.5 trillion.
Now former Bernanke is suggesting another strategy: targeting intermediate-term rates, specifically the rates on two-, three- and five-year Treasuries.
How Fed Rate Targeting Would Work
According to Bernanke, the Fed could peg the rate of intermediate-term Treasuries at a specific lower level. For example, if the yield of the two-year Treasury note were 2%, the Fed could announce its intention to hold that rate at 1% or less and be ready to buy any Treasuries maturing up to two years at a price that corresponds to 1%. Since prices of bonds rise when rates fall, the Fed would essentially be paying more than the market value of those Treasuries. After two years those notes would mature, having no impact on the Fed’s balance sheet by then.
But the strategy would only be effective if investors believed the Fed would be successful in pushing down rates to its target level. “A lot would depend on the credibility of the Fed’s announcement,” writes Bernanke. If investors didn’t believe the Fed would be successful, they would sell those securities and the Fed could end up owning most of them, unable to achieve its goal. Bernanke suggests that the Fed combine its announcement of an interest rate peg with forward guidance about the path of short-term rates, in order to boost credibility.
Targeting Rates vs. Quantitative Easing
Interest rate targeting is more precise than quantitative easing, achieving the objective of lower rates in a more direct way than QE if done right, according to Bernanke. He explains the difference: “Suppose the government is trying to increase the price of cheese. It could buy a large quantity of cheese and let the market determine the impact of the policy on the price, or it could set a price for cheese and stand ready to buy as much cheese as necessary to enforce that price.”
Quantitative easing is analogous to buying lots of cheese except the purchases are bonds. It’s a less direct way of lowering interest rates but it reduces the risk and liquidity premiums on securities, writes Bernanke.
QE and rate pegging, however, could be used together along with Fed guidance on its plans for short-term rates, writes Bernanke. All three strategies working together could conceivably lower rates along the yield curve, but Bernanke doesn’t say that.
— Check out Where to Invest If Interest Rates Go Negative on ThinkAdvisor.