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What More Could the Fed Possibly Do? A Lot

Tim Duy

(Bloomberg Opinion) -- The Federal Reserve has taken unprecedented steps in recent weeks to cushion the U.S. economy from the effects of the expanding coronavirus pandemic, including slashing its benchmark interest rate back to zero and eliciting the usual cries that the central bank is “out of ammunition.” Nothing could be further from the truth.

It’s not just the cynics that feel the Fed is now impotent. One of its own officials suggested as much when Federal Reserve Bank of Cleveland President Loretta Mester dissented against the Fed’s move to reducing rates to zero, arguing that it needed to reserve capacity for future rate cuts if needed. This was a silly argument. Policy rates of 1.50% to 1.75% were so low already that any recession, however moderate, would bring them down to zero anyway. There was no point in reserving capacity.

The Fed hasn’t paused. It has announced one liquidity program after another as central bankers work to remove roadblocks interfering with the flow of credit to the economy. In addition to an alphabet soup of lending facilities, they have revised regulatory guidance, encouraged the use of discount window lending to banks, and activated currency swap lines with global central banks to counter a global shortage of dollars.

It’s unlikely the Fed is going to stop with these kinds of actions until policy makers are confident that the flow of credit to the economy is unimpeded. Fed Chair Jerome Powell and his colleagues are determined not to repeat the mistakes of the Great Depression and allow a financial system collapse to spark a wave of bankruptcies. Moreover, they aren’t going to let another Lehman Brothers happen; the Fed learned that lesson the hard way.

Access to credit will be critical for companies needing a financial lifeline to manage through the next few months. Loans, however, will not prevent companies from closing forever. They will eventually need customers. It’s fiscal stimulus that helps ensures those customers will return when the economy reopens for business. To that end, the U.S. government has reached agreement on a $2 trillion bill aimed at limiting the economic hit of the outbreak. This doesn’t mean, however, that it’s all up to fiscal stimulus now. The Fed still has room to maneuver even after easing the credit constraints in the economy.

First and possibly foremost, the Fed has enabled the use of massive fiscal stimulus by instituting unlimited bond purchases. There is no threat of a monetary offset to the coming boom in government borrowing. It’s not yet explicit coordination of monetary and fiscal policy, but it’s about as close as we are going to get under the current institutional arrangements.

And if fiscal spending and government borrowing put upward pressure on market rates, the Fed can always employ something known as yield curve control, in effect buying as many Treasuries as needed to keep market rates from rising. In other words, there’s no need to worry about the ability of financial markets to digest debt issuance with the Fed standing ready to buy as much as needed to hold rates low. 

Also, the Fed can bolster its policy effectiveness with forward guidance. It can, for example, tie quantitative easing and yield curve control to explicit forward guidance such as a revised Evans rule to lock down expectations for policy rates. The original Evans rule said the Fed would hold rates at zero as long as unemployment was above 6.5% or inflation accelerates to 2.5%. 

Given that inflation has never lifted off substantially despite unemployment falling to 3.5%, the Fed would surely use a much lower guideline. Better yet, the Fed could drop an unemployment guideline in favor of just an inflation guideline. The original Evans rule used a near-term forecast of 2.5% inflation as a guideline to raising rates. Given the recent experience of low rates of inflation, that alone would be a huge change in policy guidance; we would need to see some very rapid and inflationary economic growth to cross that threshold.

Beyond those steps would be an even more fundamental change, such as average inflation targeting to offset any weak inflation numbers reported in the coming months or even a change in the inflation target. 

The Fed still has plenty of options to both support the economy now and accelerate the rebound when the lockdowns end. Yes, fiscal policy has a large role to play, but don’t lose focus on the effectiveness of monetary policy.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.

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