This might sound impossible, but the Federal Reserve and Treasury could make it happen
This week, the talk in Washington was all about how the government can help to create jobs. President Obama offered his suggestions Thursday night. Earlier in the week, Republican frontrunner Mitt Romney provided his plan. Each has some good ideas, but they all have drawbacks: some will cost taxpayers money in the long run and most would require Congress to act. What if a stimulus proposal could sidestep Congress, cost taxpayers nothing, and actually improve the stability of U.S. borrowing?
The Idea: QE 2.5
The Fed's Role
The Federal Reserve would be responsible for one aspect of this stimulus. As you probably know, it has already conducted two rounds of monetary stimulus, or quantitative easing ("QE"). In the first round it purchased securities to help stabilize the financial system after the crisis threw it out of whack. The second round began last November, when the Fed announced it would purchase $600 billion in longer-term Treasuries over eight months.
Both QE1 and QE2 inflated the size of the Fed's balance sheet: they resulted in the Fed injecting additional money into the financial system and holding more assets in its portfolio. But with this new step, which I'll call "QE2.5," the Fed would just replace some of its shorter-term Treasuries with long-term Treasuries.
This possibility was suggested in the monetary policy committee's August meeting. But what if it were focused on purchasing even longer-term Treasuries than QE2: what if it targeted the purchase of only 10- to 30-year notes?
The Treasury's Role
The problem, of course, is that the Treasury doesn't issue many notes with such long maturities. The demand just isn't as great for those as it is for short-term notes. For example, in August the Treasury issued $721 billion in new securities, of which just $41 billion -- less than 6% -- had maturities of at least 10 years. But now imagine that the Fed wants to buy, say, $125 billion per month in longer-term securities for six months. The Treasury could shift is issuance accordingly to provide more longer-term notes to meet some of that demand.
The Fed's Rationale
So why would the Fed bother buying longer-term securities? Its demand for long-term securities would reduce long-term interest rates. Since the government would also be issuing additional securities, however, the effect would be a little more muted, which is why the size of the program would have to be fairly large, and probably larger than QE2.
By pushing longer-term interest rates a little lower, consumers or businesses that want to take on longer-term loans will have a stronger incentive to do so and spending should rise. Since the government would be reducing its issuance of shorter-term Treasuries, the relatively smaller new supply should prevent short-term interest rates from rising much when the Fed begins selling some of its shorter-term holdings.
The Treasury's Rationale
Why would the Treasury want more longer-term debt? Let's think of an analogy. Imagine that you had two loans: a 30-year mortgage fixed at 3% and a 1-year loan at 0.5% that you have to roll over annually. Although that one-year loan is cheaper now, you know that in a couple of years it will cost you more than 3% to continue to roll it over -- and your spending habit won't allow you to pay it off. As a result, it makes sense to consolidate that short-term loan into your mortgage if you are able.
This is similar to the government's situation. The long-term interest rates that it's facing are hitting record lows, due in large part to all of the troubles in Europe. Although its short-term debt is facing very low interest rates, eventually they'll rise. For example, the one-month T-bill yield is at a ridiculous 0.01%. That's great, but as recently as 2005, the same securities' yield was above 4%. Meanwhile, 10- to 30-year Treasury notes yields currently range from 1.93% to 3.26%. If the government locks in those very low rates, it will pay more at first, but could save taxpayers a great deal of money in the long run.
And really, that higher interest rate that the Treasury is paying won't be felt on the securities it sells to the Fed: it provides the Treasury its profits each year. So the vast majority of that interest will ultimately return to the Treasury anyway as Fed profit.
There's another big benefit here: the more long-term debt that the Treasury issues, the easier it will be to roll over its smaller shorter-term debt balance over the next few decades. Its reliance on shorter-term debt could create a challenge in future years as interest rates rise. Its interest costs will be much higher for securities it issues after the current environment of ultra-low rates ends.
Of course, the Obama administration might also like this effort because neither the Treasury nor the Fed needs the permission of Congress to make this happen. That, of course, is the administration's biggest obstacle with other stimulus measures.
Most of the reasons why this idea would be so beneficial have already been explained, but here's a quick summary:
- Lower long-term interest rates will help to stimulate the economy.
- The Fed will not have to increase the size of its balance sheet.
- The Fed will not have to worry about a potential loss on the program, assuming that the U.S. does not default in the next few decades.
- The Treasury would lock in hundreds of billions of dollars of long-term debt at an ultra-low interest rate, delaying some of the potential difficulties it faces created by its large deficits. This will help buy it some time to reduce its debt once the economy strengthens.
- Taxpayers would ultimately save money by paying a very low interest rate on this debt in the long-term (and much of it would come back as Fed profits anyway).
- Congressional politics would not be a barrier.
The Potential Costs
No proposal is perfect. This idea does have some downsides, but all are relatively minor.
Could Reduce the Fed's Exit Flexibility
In a couple of years, as interest rates are rising, the Fed could have a tough time selling 30-year, fixed rate Treasuries issued at low interest rates without taking a loss. If the Fed feels pressure to reduce the size of its balance sheet as the economy strengthens, this could be a problem, in theory. In practice, however, these securities would still make up a relatively small portion of the Fed's balance sheet -- less than half. So it could sell its other shorter-term securities and just let the longer-term notes pay off over time. The worst consequence that could come from less flexibility would be a bit more inflation than would be ideal.
Critics Will Complain the U.S. Is Monetizing Its Debt
Anytime the Fed is buying Treasuries, you hear people complain that the U.S. is just monetizing its debt. This is partially true, but this proposal doesn't cause the U.S. to monetize much more debt than it already would be without the new strategy. Remember, the Fed isn't expanding its holdings of Treasuries, just swapping out shorter-term bonds for longer-term bonds.
General QE Criticisms
People who don't like quantitative easing won't like this plan either. They'll complain that as the Fed lowers interest rates, banks will benefit more than the rest of the economy. They may also worry that banks will use their inflated profits to bet in ways that could make the economy worse-off, like by creating volatility in the commodities market. These critics will never like Fed stimulus, and this technique would be no exception.
Another Fed Stimulus Effort Might Have Limited Results
Finally, some people complain that lower long-term interest rates won't help the U.S. much at this time, because fewer additional consumers or firms want to borrow anyway. This is a lesson that QE2 appeared to teach us: it may have helped a bit, but it obviously didn't push the recovery into a much higher gear: growth in the first half of 2011, which accounted for six of the eight months when the program was in effect, was just 0.7%. So QE2.5 might not have a huge impact either. Yet with unemployment stuck above 9%, do we really have the luxury of pushing aside stimulus that might help just a little -- especially when it comes with several positive side benefits and just a few potential minor negative consequences?
We'll see what the Fed decides to do in its next meeting. It may very well adopt a policy of swapping out its shorter-term securities for longer-term notes. The option was mentioned in its August meeting. If it does, then the Treasury should ramp up its issuance of longer-term debt to help satisfy the Fed's ramped up demand.