I Agree with Joe Gagnon
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
i’ve agreed with you that the Fed should buy lower quality assets, & thus agree with gagnon on this, but it’s still a weak stick…the underlying problems are still unemployment, underemployment & declining incomes; the census report last month “Income, Poverty, and Health Insurance Coverage in the United States: 2010” (PDF) showed median household income down 7.1% over the decade, & lower than 1994 for working age households…until you get employment & incomes moving up again, you cant fix housing, state & federal government revenues, or aggregate demand…
I dunno. Buying low quality assets = handing out money to holders of low quality assets. Buying low quality housing related assets = handing out money to holders of low quality housing related assets.
The Fed has already done this on a massive scale when it exchanged a large batch of squirrel excrement for T bills.
Filling a black hole that cannot be filled makes no sense. If you want to get aggregate demand up and running, you have to move resources in the direction of the sectors of the economy that will spend it. A black hole will never spend.
I would support the Fed if it found a way to move money specifically toward those parts of the economy that have not lost money in the housing market. Heck, hand me 25K and I’ll buy a foreclosure in Akron, Ohio less than a 40 days later. Within two months after that, I’ll put another 15 or 20 K of additional money into fixing that house on top of what the Fed hands me, guaranteed. That would stimulate the economy. Hand the same 25K to B of A and you’re just feeding a black hole. Now if the Fed feels the need to “buy” 25K of grass clippings and raked leaves from me in order to do it “properly” fine, its more likely to get them a return than whatever instrument they’ll get from B of A, but still, what a waste of time and energy for all involved.
interest rates can be -20% (yes negative), but that is meaningless if people with an underwater, higher interest rate loan cannot take advantage. Add to that higher bank capital requirements that encourage banks to not loan, and we have a stagnant economy.