What Should Be On The Agenda In Chicago?

The Fed plans to hold a conference in Chicago during June, with the goal of developing improved tools, targets, and strategies. Obviously, the major issue will be how to deal with the zero bound, which is expected to reoccur during the next recession. In my view, the second goal should be to develop procedures that avoid the mistakes made during 2008 (before the zero bound was hit), which were acknowledged in Bernanke’s memoir.

One key lesson from the Great Recession is that when rates are zero it’s very difficult to be too expansionary. Almost everywhere in the world, at all times in history, central banks at the zero bound adopt policies that in retrospect look too contractionary. Contemporaneous fears of inflation prove groundless. So that’s one important lesson.

Next recession, the Fed needs to immediately stop paying IOR and be far more aggressive with QE than last time. We know that inflation isn’t the real problem at the zero bound. A recent Yahoo article suggests that bond yield pegging is another option being considered:

Fed officials would also reassess how well their policy toolkit worked in combating the deep recession that followed the financial crisis of 2008-09, and consider what additional tools might be added to prepare for the next downturn. He mentioned a crisis-time policy implemented by the Bank of Japan, which would seek to establish a temporary ceiling for Treasury debt yields at longer maturities, as a tool that might be considered.

That’s a reasonable option, but it’s not enough by itself. Indeed, doing more concrete steps at ultra-low interest rates is not enough, as ultra-low interest rates represent a sort of prediction of policy failure, a prediction that NGDP will grow too slowly to achieve the Fed’s dual mandate. The goal should be to prevent the zero bound from occurring in the first place, not just to deal with it appropriately. Once you are there, you have already (accidentally) adopted an inadequate policy.

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Gary Anderson 3 weeks ago Contributor's comment

The concept of bonds tied to GDP growth is an interesting concept. But clearly long bonds are not reflecting growth in our economy at all. They reflect demand for bonds as money, bonds as collateral. Would bonds that grew in yield like the way bonds used to behave have much appeal? Clearinghouses mark to market the bonds as collateral. If yields rose, price would go down. Yes they could hold to maturity and get par but clearinghouses only care about market value at any given moment. Margin calls would certainly be required if those bonds were used as collateral and the economy grew.