In his testimony to the Congress this week, Fed Chairman Ben Bernanke left the door open to further monetary stimulus but made it clear that such action is not imminent. This reluctance to act may seem puzzling given the widespread view that the economic recovery is too weak. In response to a Senator's question, Chairman Bernanke gave a hint as to the reasoning behind the Fed's reluctance, saying that "no one can say that the Federal Reserve did not act aggressively" to prevent an economic depression last year.
Indeed, the Fed did act aggressively both in lowering its traditional policy interest rate and in a number of unprecedented and unconventional measures. It is only natural to be cautious when operating outside familiar territory, and the Fed has spent most of the past 12 months waiting to see how the economy would respond to its policies. Now the verdict is in: the Fed's policies were successful as far as they went. They turned an incipient depression into a modest recovery, but they did not go quite far enough to obtain a truly robust and satisfactory recovery.
The Federal Reserve's own forecast shows that it will take at least three or four years for employment to return to its long-run sustainable level. This extended period of high unemployment represents a massive waste of productive labor and untold personal suffering of unemployed workers. The Fed should be aiming to get us back on track within two years. And the urgency of Fed action is all the more important because Congress has refused to provide more stimulus.
In addition, it is now apparent that deflation is a more serious risk for the US economy than inflation. The latest data show overall declines in consumer and producer prices. Even after excluding the volatile food and energy components, core inflation has trended well below the 2-percent level that central banks view as optimal for economic growth and that the Fed has adopted as its goal.
Clearly, the case for monetary stimulus is strong. But what form should it take? With financial markets now in healthier shape, the Fed does not need to invoke the "unusual and exigent circumstances" clause to lend directly to the private nonbanking sector. Rather, it should return to its traditional roles of lending to the banking system and buying Treasury securities. Three actions, in particular, would be helpful at this time.
First, the Fed should lower the interest rate it pays on bank reserves to zero. This is a small step, as the current rate is only 0.25 percent, but there is no reason to pay banks more than the rate paid by the closest substitute, short-term Treasury bills. Three-month Treasury bills currently yield 0.15 percent, and that rate, too, should be brought down to zero.
Second, the Fed should bring down the rates on longer-term Treasury securities by targeting the interest rate on 3-year Treasury notes at 0.25 percent and aggressively purchasing such securities whenever their yield exceeds the target. That is a 65-basis point reduction from the current rate of 0.90 percent. This step would also push down longer-term yields and reduce a wide range of private borrowing rates, encouraging business investment, supporting the housing market, and boosting exports through a weaker dollar. Moreover, pushing down yields on short- to medium-term Treasury securities is precisely the strategy for fighting deflation recommended by Ben Bernanke in 2002.
Finally, the Fed could bolster the stimulative effects of these actions by establishing a full-allotment lending facility to enable banks to borrow (with high-quality collateral) at terms of up to 24 months at a fixed interest rate of 0.25 percent.
These measures are all within the Federal Reserve's established powers. They pose essentially no risk to the Fed's balance sheet. They would reduce unemployment roughly as much as a 2-year $600 billion fiscal package and yet they would actually reduce the federal budget deficit. And they can be reversed quickly should the balance of risks shift from deflation to inflation.
Given the unsatisfactory outlook for unemployment and inflation and the lack of action by Congress, that is the right medicine for the US economy now.