3 Things The Fed Could Do

Jun 7, 2012
Originally published on June 8, 2012 9:55 am

When the leaders of the Fed meet later this month, will they take any new steps to try to boost the economy and bring down unemployment?

In his testimony before Congress today, Ben Bernanke shed basically no light on this question.

So I called Joseph Gagnon, a former Fed economist now at the Peterson Institute, and he walked me through a few things the Fed might do if it decides to do more.

I'll get to that in a sec, after a bit of context.

The Fed has two main jobs. It's supposed to keep both inflation and unemployment low. And it always faces a tradeoff. The things that bring down unemployment tend to push up inflation, and vice versa.

At the moment, inflation is where the Fed wants it to be — about 2 percent. But unemployment is too high — over 8 percent. (Before the recession, unemployment was about 5 percent.)

The Fed has already taken several big steps to try to bring down unemployment. It does this mainly by pushing interest rates down, which is supposed to encourage people to borrow and spend money, and businesses to hire.

Here are three things Gagnon said the Fed could do, if it wanted to do more:

1. Keep Twisting

The Fed has been selling short term government bonds and buying long-term government bonds. People call this "Operation Twist," and the the main effect is to push long-term interest rates down. (Short-term interest rates have remained super low, largely due to other Fed policies.) The Fed may announce that it's extending this program by a few months.

Gagnon says it's pretty likely that the Fed will do this. In fact, it's so likely that it's already priced into government bonds. So the impact on the economy would be quite low.

2. QE3

The Fed could print more money — tens or hundreds of billions of dollars — and start buying up long-term bonds on the open market. This is called quantitative easing, or QE, and it's something the Fed has done twice in the last few years. People call the (hypothetical) next round QE3.

The Fed has largely bought Treasury bonds in previous rounds of QE. But the yield on long-term Treasury bonds is already so low that there's not much more the Fed can do on this front.

The Fed has also bought government-guaranteed mortgage bonds as part of QE. Mortgage rates are quite low (below 4 percent) but they could go lower. Buying mortgage bonds could be the sweet spot, Gagnon says — something the Fed might actually do, and that could have a significant impact on the economy.

3. Extra inflation

The Fed could announce that it is prepared to tolerate a brief period of higher inflation, until unemployment falls to normal levels. This could make a noticeable difference in the economy Gagnon says.

But the Fed's not likely to do it. After a bout of high inflation in the late 70s and early 80s, the Fed spent 30 years proving to the world that it could keep inflation low.

"To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do," Bernanke said at a press conference earlier this year.

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