After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead by Blinder Alan S

Author:Blinder, Alan S. [Blinder, Alan S.]
Language: eng
Format: mobi, epub
Publisher: Penguin Press HC, The
Published: 2013-01-23T15:00:00+00:00

Peg a Longer-Term Interest Rate

Conventional monetary policy can be understood as pegging one particular overnight interest rate—the federal funds rate—by buying or selling reserves as necessary. By extension, the Fed could buy or sell, say, 6-month T-bills as necessary to force the 6-month Treasury rate to be, say, 15 basis points. Or it could buy or sell 2-year Treasury notes to force the 2-year rate to be, say, 1 percent. Or it could buy or sell 10-year Treasury bonds to force the 10-year rate to be 1.5 percent. And so on. The aim would be to shrink the spread between, say, the federal funds rate and some longer-term interest rate.

In principle, the Fed can peg any interest rate it wants to at whatever number it wants—if it is willing to buy or sell the requisite amounts of the relevant security. Indeed, during and after World War II, the Fed did peg interest rates on government bonds at extremely low levels. But doing so means that the central bank loses control over how many securities it owns and the volume of bank reserves it creates—which is just what happened during World War II. Why? Because to push a bond rate down to some target level, the central bank must stand ready to buy as many bonds as necessary to do the job—a volume of purchases it cannot know in advance. That’s the main reason why central bankers shun the idea. They are taught in central banking kindergarten never, ever to lose control of their balance sheet because that might cost them control of bank reserves and the money supply.

That said, the Fed did lose control of its balance sheet somewhat when it instituted “QE3” in September 2012. This brings us to . . .

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