A NEW DIRECTION

FOR THE FEDERAL

RESERVE
Expanding the Monetary Policy Toolkit

REPORT BY MIKE KONCZAL AND J.W. MASON

DECEMBER 2017
 ABOUT THE ROOSEVELT INSTITUTE

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ABOUT THE AUTHORS ACKNOWLEDGMENTS

Mike Konczal is a Fellow with the Roosevelt Institute, where We thank Josh Bivens, Gerald
he works on financial reform, unemployment, inequality, and Epstein, and Lenore Palladino
a progressive vision of the economy. He has written about for their comments and insight.
the economy for numerous publications, including The Nation, Roosevelt staff Nell Abernathy,
The Washington Post, and Vox. He received his M.S. in Kendra Bozarth, Katy Milani,
Finance and B.S. in Math and Computer Science both from Jennifer R Miller, Marshall
the University of Illinois. Prior to joining the Roosevelt Institute, Steinbaum, and Alex Tucciarone
he was a financial engineer at Moodys KMV working on all contributed to the project.
capital reserve models.
This report was made possible
J.W. Mason is a Fellow at the Roosevelt Institute, where he with generous support from the
works on the Financialization Project, and an assistant professor Open Philanthropy Project.
of economics at John Jay College, CUNY. His current research
focuses on the history and political economy of credit, including
the evolution of household debt and the changing role of
financial markets in business investment. He also works on
history of economic thought, particularly the development
of macroeconomics over the twentieth century.
Executive Summary
The Great Recession forced the Federal Reserve to think beyond conventional monetary
policy toolsprimarily adjusting the overnight federal funds rate targetto reverse the
economic downturn and steer the economy toward healthy demand. With rates close to
zero, the Fed turned to what was viewed as unconventional monetary policy, most notably
by purchasing longer-term assets, like treasuries and mortgage securities, a strategy known
as quantitative easing (QE). Even with these changes, there is strong evidenceincluding
low labor force participation and wage stagnationthat the Fed has not brought us back to
full employment or brought the economy back to its historical path of growth. Most of the
recovery has come not from a genuine increase in output, but from a reduced expectation of
the economys potential.

There are many reasons why monetary policy cant go back to the status quo. When the next
recession happens, its unlikely that reducing the short-term interest rate will be enough
to stabilize demand, simply because rates will almost certainly not be high enough for a big
enough rate reduction to give the economy the boost it will need. In addition, monetary
policy always has effects on the distribution of income and wealth and on the direction of
credit, as well as its volume. We should adopt a more expansive view of the central banks
role in providing appropriate credit conditions. This is less of a challenge, however, as we are
also remembering old tools. It was universally understood in the past that it was necessary
for the Fed to intervene across the entire distribution of interest ratessetting multiple
rates (both long- and short-term rates, for instance) and playing a more active role in
managing credit creation in order to maintain full employment.

Though changes to the Federal Reserves current target, to either a new one or a higher
inflation target, are worth investigating, we believe that this change is unlikely to work
outside a broader conceptual shift. There are institutional reasons why the Federal Reserve
hasnt been able to hit its target. In addition, the link between conventional monetary policy
and real economic activity is weakening. There is not a single interest rate, but many
interest rates, many asset markets, and many different kinds of institutions participating
in them. It has become increasingly clear that effective macroeconomic policy cannot be
conducted on the basis of a single unique target.

Following the example set by the Bank of Japan (BOJ), the Fed should target long-term
interest rates in addition to the overnight rate that is the current focus of monetary policy.
The Fed should be explicit about support for public borrowing, allowing the government to
employ countercyclical fiscal policy along with monetary policy. The Fed should purchase
state and local debt, thus combating the pro-cyclical pressure of state and local spending

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cuts during recessions. The Fed and the Treasury should better coordinate bond rates,
ensuring that these two arms of the government are not at cross-purposes. The Federal
Reserve should purchase a broader range of private liabilities, which will be necessary to
make the transmission of routine monetary policy more reliable. We must also shift how
Fed officials view their own role as well as how Congress thinks ofand legislates forthe
Fed. While the Fed must adopt a broader view of its responsibilities, Congress must also take
action in areas that were traditionally delegated to the central bank.

This list is not meant to be exclusive, exhaustive, or definitive. But we hope that it can
begin a broader discussion of expanding the scope and scale of interventions by the Fed.
The Federal Reserve may be uncomfortable redefining its role in the macroeconomy. But
whether it likes it or not, the central bank is a central planner that can shape both the
character and the level of economic activity in the U.S. The Fed should embrace this role
and the democratic accountability that goes with itand exercise its power toward the
public good.

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Introduction
The Great Recession changed everything, especially the way the Federal Reserve (the Fed)
carried out monetary policy. In December of 2008, during a period of the Great Recession
in which the United States was losing around 700,000 jobs each month, the Fed lowered
the overnight federal funds rate target to between zero and 0.25 percent to boost the
economy. Controlling this overnight rate, and solely this rate, to fight economic recessions
and overheating has been the basis of conventional policy in the years leading up to 2008.
With rates close to zero, however, the Fed, couldnt continue to lower the target to a negative
value to reverse the Great Recession. Instead, they turned to whatat the timewas viewed
as unconventional monetary policy, most notably by purchasing longer-term assets, like
treasuries and mortgage securities, a strategy known as quantitative easing (QE).

The Feds strategy was less new than it was generally believed to be at the time, as these
new tools had actually been part of the monetary policy toolkit for much of the 20th
century. However, as the Fed embarked on its QE strategy, this approach was considered
brand new and triggered considerable debate in the field of monetary economics. The ways
that the Federal Reserve can conduct policy at the zero lower boundwhen the short-
term federal funds interest rate is at or near zero percenthas inspired a research agenda
to expand and diversify the tools within the central banks disposal to reverse inevitable
downturns in our economy. For the first time in many years, the appropriate instruments
and targets for monetary policy are up for debate.

It is an open question today whether there has been a full recovery from the Great
Recession, and how much slack still remains in the economy. Labor force participation
still remains low. Meanwhile, wages remain slack. Most of the recovery has come not from
a genuine increase in output, but from a reduced expectation of the economys potential
(Mason 2017). By 2019, it is likely that our recovery over the past 12 years will have been
slower than the comparable period after 1929 (Leonhardt 2017). Nonetheless, central
bankers seem prepared to declare victory and go home. By ending the third and final round
of QE in September of 2014 and raising interest rates in December of 2015, the Federal
Reserve has moved away from its unconventional policy regime of QE. As Bernanke (2017)
observes, officials at the Fed and other central bankers believe they see the light at the end
of the tunnel and, for the most part, are no longer worried about their ability to achieve
their macroeconomic goals with the existing tools.

It is nearly certain that when the next recession comes, the Fed will again be forced to resort
to unconventional policy remedies. And even before then, there are substantial questions
about the extent to which demand managementi.e., the ways in which the Federal

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Reserve stimulates the economy by hitting the gas pedal or brake through the instrument
of increasing or decreasing the single interest rateis consistent with larger goals for the
economy, including financial stability, fostering productive investment and good jobs, and
directing societys resources toward urgent social problems, such as climate change.

There are substantial policy questions about the

ways in which the Federal Reserve stimulates the
economy by hitting the gas pedal or brake, by way
of increasing or decreasing the single interest rate,
is consistent with larger economic goals, including
ensuring financial stability, fostering productive
investment and good jobs, and directing societys
resources toward urgent social problems, such as
climate change.

Historically, macroeconomic demand management by central banks has involved a much

broader range of both goals and tools compared to what is used today (Epstein 2006). And
while the narrow approach based on a single interest rate appeared to work reasonably well
in the U.S. and other developed countries in the two decades or so before 2007, today it is an
inadequate description of what central banks have been doing or what they should be doing.
In the words of IMF Chief Economist Olivier Blanchard (2011):

Before the crisis, mainstream economists and policymakers had converged on a beautiful
construction for monetary policy. To caricature just a bit: we had convinced ourselves that
there was one target, inflation. There was one instrument, the policy rate. And that was
basically enough to get things done. If there is one lesson to be drawn from this crisis, it is
that this construction wasnt right, that beauty is unfortunately not always synonymous
with truth. The fact is that there are many targets and there are many instruments.

The goal of this paper is to begin to develop a new monetary policy toolkitone that will
broaden the set of countercyclical tools and flesh out some of the many instruments that
Blanchard thinks central banks should be exploring.

In Section One, we discuss why, in response to the Great Recession, it is essential that
the Federal Reserve develop a broader monetary policy toolkit. We then, in Section Two,
discuss some of the most widely discussed monetary policy reforms currently being
considered to stimulate post-recession growth. In particular, we review recent proposals

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for modifying the inflation target of monetary policy and for allowing the overnight
interest rate to move below zero. We explain why we believe these changes to the conduct
of monetary policy are not sufficient by themselves to reliably maintain full employment.
Finally, in Section Three, we suggest other approaches that we believe the Federal Reserve
should explore and adopt as part of their toolkit. Six stand out for us:

1. Setting long-term interest rates

2. Increasing support for public borrowing

3. Purchasing state and local debt

4. Coordinating Treasury and Federal Reserve policy

5. Purchasing a greater range of private debt

6. Shifting from a monetary policy to a credit policy framework

This list is not meant to be exhaustive or definitive, but we hope that it can begin a broader
discussion of expanding the scope and scale of interventions by the Fed. The economys
ability to weather recessions, and to meet human needs even in good times, depends on the
Fed getting out of the narrow box it trapped itself in before 2008 and is only just finding its
way out of today.

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SECTION ONE

Why We Need a New Toolkit

In this paper, we argue that the Fed should consider a broad conceptual shift in its mandate
from a focus on inflation targeting to broader credit policy. This requires a more extensive
set of tools than what is currently on offer in conventional monetary policy. In this
section, we outline why this shift is needed.

The Fed should consider a broad conceptual shift in

its mandate from a focus on inflation targeting to
broader credit policy. This requires a more extensive
set of tools than what is currently on offer in
conventional monetary policy.

Its important to be clear on what we mean by conventional monetary policy. Lets define the
conventional view, which dominated finance in the decades before the Great Recession, as
follows: Monetary policy consisted of the manipulation of a single instrumentan overnight
interbank interest rate instrument. This instrument was meant to manage one or, at most,
two targets: a single inflation rate and perhaps also an unemployment rate. (In practice,
the Fed has treated full employment as simply meaning whatever level of unemployment
is consistent with its inflation target, so the notional two targets are really just one.) In
the consensus view, setting a single overnight interest rate at the appropriate level would
be sufficient to stabilize inflation, output, and unemployment at socially desirable levels,
and this would be consistent with stable trajectories for debt and asset prices, as well.
Macroeconomists believed that the economy was characterized by something close to the
divine coincidencethat full employment, maximum sustainable growth, and stable
inflation go together with no trade-offs between them (Blanchard 2016). In theory, if the
policy interest rate was set at the right level, the central bank would achieve all that could be
asked from it as far as the macroeconomy was concerned.

In the wake of the Great Recession, its clear that these promises were not fulfilled. It
is universally agreed that the single interest-rate instrument is insufficient to reliably
stabilize demandmost obviously because of the zero lower bound, but also because
changes in the policy interest rate are not reliably transmitted to the larger economy. It
is also increasingly recognized that the central banks macroeconomic goals cannot be
reduced to a single target. In part, this is because the divine coincidence may not hold

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in realitystable inflation, full employment, and maximum sustainable growth may each
require a different level of aggregate demand. In addition, central banks often need to
think about other targetsfinancial stability, and perhaps also income distribution and
the sustainability of public debt. Finally, the immediate response to a financial crisis on
the scale of 2007-2009 requires extensive intervention in the financial system, often in
new ways, which may have lasting implications for the conduct of monetary policy even in
normal times. Its clear that the central banks tools are weaker, and its job is bigger, than
most people believed a decade ago.

The unconventional monetary policy of the past decade largely consisted of the central
bank directly purchasing long-term debt and other securities from the market through
the QE program, guiding the financial markets on the future path of those purchases, and,
during the initial liquidity crisis, providing emergency loans to the financial sector so it
could weather the economic storm during the initial liquidity crisis.

Today, many inside and outside the Fed hope that it will be possible to fight the next
recession by relying on conventional policy, supplemented by the handful of unconventional
tools that were tried after 2007. We disagree. We believe new tools for monetary policy are
still urgently needed for the following reasons:

REASON 1: EXPERIMENTAL TOOLS ARENT

SO EXPERIMENTAL.
A larger monetary policy toolkit is not as radical as it might seem. Tools that seem
unconventional today in fact have a long history in monetary policy in the U.S. and
elsewhere. In the words of the former Bank of England Monetary Policy Committee
member Adam Posen (2012):

you only need to look back at monetary history to see the obvious: central banks
have engaged in extended periods of administrative guidance, of doing very active
directed lending in particular sectors, and especially of engaging in market operations
on financial assets other than government securities It is quite literally a prehistoric
argument to assert that central banks are engaged in experimental, unprecedented, or
somehow scandalous and dangerous policy maneuvers today.

Indeed, it was universally understood in the past that it was necessary for the Federal
Reserve to intervene across the entire distribution of interest ratessetting both long-
and short-term rates, for instanceand playing a more active role in managing credit
creation in order to maintain full employment. New research from the Federal Reserve

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Board emphasizes this for the 1920s. In the 1920s, the Federal Reserve targeted a number
of different interest rates, as well as using their balance sheets, to drive monetary policy.
Several notable tools included the purchasing of bankers acceptances, which set prices for
money market instruments, as well as aggressive open market operations in government
securities (Carlson and Duygan-Bump 2016).

Tools that seem unconventional today in fact

have a long history in monetary policy in the U.S.
and elsewhere.

During World War II, the Fed directly set long-term interest rates. This was like QE,
but the Fed announced a target price for securities rather than a specific amount to be
purchased. Starting in 1942, the Fed successfully committed to a 2.5 percent ceiling on
long-term government bonds, which was maintained until 1947 (Hetzel 2001). In the
postwar decades, Fed staff promoted a broad range of credit-direction tools to developing
countries, establishing new central banks as part of monetary policy best practice (Epstein
2013). Given this, there is no reason to exclude a broader range of instruments for actively
directing credit from the Feds toolkit going forward, nor should we treat a more expansive
toolkit as some radical measure that should be considered only as a last resort.

REASON 2: THE TOOLS RELIED ON IN RECENT

YEARS WONT BE ENOUGH TO DEAL WITH THE
NEXT CRISISAND THERE WILL BE A NEXT CRISIS.
Sooner or later, the U.S. will experience another recession. When that happens, its unlikely
that reducing the short-term interest rate will be enough to stabilize demand, simply
because rates will almost certainly not be high enough for a big enough reduction. Figure 1
shows the federal funds rates since 1988. In the recession of 1990 to 1991, the federal funds
rate fell from 8.25 percent to 3 percent, a fall of 5.25 percent. In the recession of 2001, the
federal funds rate fell from 6.5 percent to 1.0 percent, a fall of 5.5 percent. Before the much
more severe Great Recession, interest rates were at 5.25 percent and then taken to zero,
where they remained until December 2015.

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 NOT ENOUGH ROOM FOR NEXT RECESSION

12
10
Federal Funds Rate

6% drop in
1990 Recession
6

5.25% drop in
2001 Recession
4

5.25% drop to zero

in Great Recession
2
0
9/1/88
4/1/89
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3/1/99
10/1/99
5/1/00
12/1/00
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FIGURE 1 Source: St. Louis Fed, FRED Economic Data: https://fred.stlouisfed.org/series/FEDFUNDS

During the summer of 2017, the federal fund rate was at 1.15 percent. In June of 2017, Fed
officials estimated that the federal funds rate will only be at 2.9 percent during 2019, with
a longer-run estimate of 3 percent. These estimates have generally been too optimistic
about the recovery, but even if they are true, it shows that there may be little space for
conventional interest rate setting policy to respond to any negative shock to demand. If the
next recession requires a fall in the federal funds rate of 5.5 percent, as it did in the 1990 and
2001 recessions, there simply wont be the room to carry it out with current estimates.

If the next recession requires a fall in the federal

funds rate of 5.5 percent, as it did in the 1990 and
2001 recessions, there simply wont be the room to
carry it out with current estimates.

The larger problem here is twofold. First, there are widespread arguments that demand
is persistently weaker today than in the past. Whether this is because investment is
depressed by a lack of major new technologies or by corporate short-termism, or whether
consumption is depressed by higher inequality or other factors, the effect is the same: It
takes a lower interest rate to reach the economys potential even in normal times. Second,

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there is good reason to doubt that the interest rate controlled by the Fed is as tightly linked
to macroeconomic outcomessuch as growth and employmentas it once was. Thanks to
deregulation and to institutional changes in the financial system, neither market interest
rates nor credit volumes respond as strongly to monetary policy changes as they did in the
postwar era. The result is that dealing with the next recession through conventional interest
rate policy would require a larger fall in interest rates than in the past, while rates are likely
to already be quite low.

The unconventional policies adopted so far

primarily QEare a step in the right direction, but
inadequate to deliver the growth and job creation
that the economy needs.

The unconventional policies adopted so farprimarily QEare a step in the right

direction, but inadequate to deliver the growth and job creation that the economy needs.
Todays low rates by themselves are a strong case for alternative tools. The failure of seven
years of overnight interest rates at zero to spark more than a weak and halting recovery
shows that the interest rate setting tool is less reliable than it was formerly believed to be.
This may be because changes in the overnight rate dont get passed through to the longer
market rates that matter for private borrowers (Mason and Jayadev 2015). Or it may
be because investment, hiring, and other real economic activities are not responsive to
interest ratesor to credit conditions generallywhen demand is weak. This is the old idea
that you cant push on a string. Either way, the failure of the Feds ultra-expansionary
policy to produce a strong recovery from the recession gives us reason to doubt the power
of existing tools.

Todays low rates by themselves are a strong case for

alternative tools. The failure of seven years of
overnight interest rates at zero to spark more than a
weak and halting recovery shows that the interest
rate setting tool is less reliable than it was formerly
believed to be.

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REASON 3: HITTING MULTIPLE TARGETS REQUIRES
MULTIPLE INSTRUMENTS.
It is increasingly clear that effective macroeconomic policy cannot be conducted on the
basis of a single instrument and a single target. For many years, macroeconomic policy
was based on the idea of divine coincidence, in which it was assumed that the same
level of output that fully utilized the economys productive potential would also generate
full employment and price stability. Both empirical and real-world evidence makes it
increasingly clear that this is not the case (Blanchard 2016).

It is increasingly clear that effective macroeconomic

policy cannot be conducted on the basis of a single
instrument and a single target.

At the same time, the range of outcomes that macroeconomic policy needs to address
has broadened to include financial stability and the distribution of income and wealth.
These outcomes have become increasingly prominent on central bank agendas over the
past decade. As Tinbergen (1952) pointed out long ago, a single macroeconomic policy
instrument cannot control more than one independent target. For the moment, central
banks seem to be trying to achieve adequate outcomes on all targets with the single
instrument of an overnight interest rate. But such an approach is likely to lead to, at
best, mediocre outcomesits a compromise rate, which is too low to rein in financial
exuberance while too high to generate full employment or fully utilize the economys
productive potential.

It is increasingly clear that even if the central banks objective is defined myopically as price
stability, the overnight interest rate is an inadequate interest rate to achieve even that.
Despite an overnight rate at zero, the Fed has undershot its inflation target almost every
month since 2008. During the recession and the immediate post-recession period, Fed
officials recognized the inadequacy of the short-term interest rate and worked to develop
a set of alternative toolsmainly QE and forward guidancethat could more effectively
boost desired spending by the private sector. The effectiveness of these tools is, at least,
questionable; though QE probably achieved more than forward guidance, neither were able
to stimulate private sector borrowing on a large scale (Friedman 2014).

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REASON 4: THE FINANCIAL CRISIS SHOWED THAT
ALL LIQUIDITY IS NOT CREATED EQUAL.
A fourth reason to explore a broader toolkit comes from the extraordinary actions taken by
the Fed and other central banks in response to the financial crisis of 2007-2009. While the
Feds function as lender of last resort in crises and its role in macroeconomic stabilization
are conceptually distinct, the crisis response has implications for macroeconomic policy
in general.

The response to the crisis both demonstrated and reinforced the Feds deep involvement in
financial markets. While many of the special facilities to shift risk out of the banking system
have been wound down, some remain in place. Even today, the Fed is the final purchaser of
10-20 percent of new residential mortgages in the U.S., as it rolls over its existing stock of
mortgage-backed securities. Even if demand management and economic stabilization were
not the original goals of these asset purchases, they still have important effects on aggregate
demandin this case, by supporting mortgage lending. The crisis response also demonstrated
the range of actions available to the Fed in an emergency. Fed leadership should not be allowed
to plead helplessness in an emergency of mass unemployment or urgent, unmet social needs,
but should show the same creativity in addressing them they brought to the financial crisis.

Conversely, while the crisis was a lesson in the speed and flexibility with which the central
bank can act when it wishes to, it was also a lesson in the shortcomings of financial markets.
A narrow definition of monetary policy made sense when it seemed that, if the Fed simply
set the overall level of liquidity or credit creation in the economy, private markets would
allocate it to the most socially beneficial uses. The mortgage bubble and the ensuing collapse
of the securitized-mortgage market make that claim less defensible. If we cant count on
private finance to efficiently allocate credit, it is the responsibility of policymakers to take
a more active role in steering credit through the economy. Paul Krugman (2016) suggests
that this broader point about the efficiency of financial markets should be one of the main
lessons of the crisis. The experience of the past decade suggests:

a broader rationale for policy activism than most macroeconomistseven self-

proclaimed Keynesianshave generally offered in recent decades. Most of them
have seen the role for policy as pretty much limited to stabilizing aggregate demand.
Correcting asset markets when they go wrong wasnt part of the mandate, because who
were policymakers to claim that they were smarter than private investors? Once we admit
that there can be big asset mispricing due to liquidity and collateral constraints, however,
the case for intervention becomes much strongerThere is more potential for and power
in intervention than was dreamed of in efficient-market models.

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REASON 5: MONETARY POLICY CHOICES AFFECT
THE DISTRIBUTION OF INCOME AND WEALTH.
A fifth reason to be exploring alternative tools is that monetary policy, in both conventional
and unconventional forms, always has allocation and distributional effects. Decisions to
tighten or loosen policy do not simply raise or lower the overall level of economic activity
while leaving its composition of these activities unchanged. Monetary policy inevitably
has greater effects on certain sectors, which are more sensitive than others to changes in
credit conditions. In the U.S., for instance, monetary policy has operated disproportionately
through the housing sector (Leamer 2007).

Monetary policy choices also have important effects on the distribution of income
and wealth (Binder 2015). Expansionary policy can raise wages and improve income
distributionthere is evidence that in the absence of QE, inequality would have increased
in the post-recession period by even more than it did (Bivens 2015). Conversely, weak policy
responses can lead to less growth with slower wage gains, reduced productivity growth,
and lower labor force participation. Whether this decline in potential economic activity,
often referred to as hysteresis, is permanent or simply requires more aggressive effort to
combat is a current frontier of debate. Either way, however, it shows us that, contrary to
economic models, money is not neutral in the long run, because the state of monetary policy
determines how the economy grows towards the long-term.

Finally, higher and lower interest rates redistribute income between debtors and creditors.
Indeed, the rise in the long-term household debt-income ratios after 1980 was due not
to higher borrowing by households, but by the effect of higher real interest rates on the
existing stock of household debt (Mason and Jayadev 2015). Monetary policy decisions must
take into account their effects on distribution and allocation of credit, as well as on the level
of demand. It is unlikely a single instrument will be sufficient to meet all these goals. Indeed,
there is an argument that policymakers should be much more concerned with the effects of
their choices on distribution than on long-term growth (Furman 2017).

Some have used distributional impact as an argument against unconventional policy

central bank asset purchases have, in this view, mainly benefited higher-income households
that own most financial assets and have been the beneficiaries of whatever rise in asset
prices QE has produced. While these concerns should be taken seriously, its important
that the direct distributional effects of unconventional policy can also go the other way
by reducing interest rates faced by lower-income borrowers and through their effect on
house prices. In any case, these direct distributional effects have probably been dwarfed
by the distributional impact of higher or lower unemployment (Bivens 2015). So, while

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distributional concerns are important, it would be wrong to use them to argue against the
Feds efforts to boost demand over the past decade. But they are likely to be important
going forward, especially as policymakers must weigh the risks of above-target inflation
against slower growth of employment and wages. The inherited framework is unlikely to be
adequate here.

REASON 6: LIKE IT OR NOT, THE FEDS POLICY

CHOICES STRONGLY INFLUENCE THE DIRECTION
OF CREDIT.
Finally, a sixth reason, closely related to the previous three, is that the mix of assets
purchased by the central bank inevitably affects the kind of credit created, as well as its
volume. This was most visible during the crisis. During 2007 and 2008, it was the decisions
of the Fed that determined which troubled financial institutions would survive, which
would be absorbed by other institutions, and which, like Lehman Brothers, would be allowed
to fail. During the summer of 2008, when the commercial paper market that provides short-
term financing to the nations largest corporations had essentially ceased to function, the
Fed stepped in to replace private lenders. By making loans directly to non-financial, as well
as financial, businesses that had previously borrowed in the commercial paper market,
the Fed effectively replaced private banks as the source of short-term loans for corporate
America. During the slow recovery that followed, the Fed continued purchasing large
volumes of mortgage-backed securities, as well as longer-dated treasuries through the QE
programs. The explicit logic of these policies was to induce private financial institutions to
hold a different mix of assets than they would have chosen on their ownultimately, in the
hopes of financing activities that would eventually boost aggregate demand.

We should adopt a more expansiveand thus more

realistic and more politically productiveview of the
central banks role in directing credit and shaping
outcomes in financial markets.

For manyboth inside and outside the Fedthese kinds of large-scale asset purchases
represent undesirable distortions of financial markets. But, as Bernanke (2017) notes,
these criticisms are incoherent. The goal of all monetary policy is to set financial
conditions consistent with full employment and stable prices. So, it is always going to
produce a different pattern of asset prices and yields than it would have obtained otherwise.

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And in any case, there is no such thing as undistorted values of interest rates, term, and
risk premia, etc.these are always influenced by the policy choices of both the central bank
and the elected government. In this paper, we suggest that the interventions of the crisis
should not be seen as anomalous, but rather should lead us to adjust our view of central
banking in normal times. We should adopt a more expansiveand thus more realistic and
more politically productiveview of the central banks role in directing credit and shaping
outcomes in financial markets. The crisis and the response to it are not exceptional. They
reflect the need for, and reality of, conscious planning in financial markets. In the words of
Bagehot: Money will not manage itself.

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SECTION TWO

Why the Current Toolkit Is Insufficient

This paper joins an ongoing debate over how the Federal Reserve responded to the Great
Recession and how it should react to future recessions. The assumption in most of these
discussions is that monetary policy will continue to be conducted using a single instrument.
The focus is on extending the range of this instrument via negative rates and forward
guidance, and/or changing the target that guides its use. A number of alternative targets
have been suggested. Major examples include a higher inflation target; the path of the price
level, rather than the inflation rate; nominal gross domestic product (NGDP)either its rate
of change or its level path; nominal wage growth; and asset prices. Hybrid targets are also of
course possible, such as adopting a price level target during periods when the interest rate is
at zero and the current inflation target the rest of the time.1

NOT HITTING THE TARGET: WHY THE 2 PERCENT

INFLATION TARGET ISNT WORKING
Many economists and policymakers suggest that a major reason for the central banks
failure to restore normal levels of economic activity and growth in the wake of the
financial crisis is the inflation target, which most modern central banks make their main
macroeconomic objective.

Going into the Great Recession, it was understood that the Fed had a 2 percent inflation
target. This was made explicit in January 2012, when the Fed announced, [T]he Committee
judges that inflation at the rate of 2 percent, as measured by the annual change in the price
index for personal consumption expenditures, is most consistent over the longer run with
the Federal Reserves statutory mandate. This target or judgment behind it hasnt changed
since (Federal Reserve 2012). In fact, of course, the 2 percent inflation target had guided Fed
policy since at least the late 1990s and was embedded in widely used models of monetary
policymaking, such as the Taylor Rule.

Binder and Rodrigue (2016) give a good overview of many of these alternatives. An asset price target is most forcefully
1

advocated by Roger Farmer (2009). The hybrid inflation/price-level target was recently proposed by former Federal
Reserve Chair Ben Bernanke (Bernanke 2017).

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 %
INFLATION IS CONSISTENTLY BELOW TARGET

3%
2.5% Core CPI, Quarterly Change from a Year Ago

Two Percent Target

2%
1.5%
1%
0.5%
0%
7/1/97
12/1/97
5/1/98
10/1/98
3/1/99
8/1/99
1/1/00
6/1/00
11/1/00
4/1/01
9/1/01
2/1/02
7/1/02
12/1/02
5/1/03
10/1/03
3/1/04
8/1/04
1/1/05
6/1/05
11/1/05
4/1/06
9/1/06
2/1/07
7/1/07
12/1/07
5/1/08
10/1/08
3/1/09
8/1/09
1/1/10
6/1/10
11/1/10
4/1/11
9/1/11
2/1/12
7/1/12
12/1/12
5/1/13
10/1/13
3/1/14
8/1/14
1/1/15
6/1/15
11/1/15
4/1/16
9/1/16
2/1/17
FIGURE 2 Source: St. Louis Fed, FRED Economic Data: https://fred.stlouisfed.org/series/PCEPILFE

As seen in Figure 2 above, the Fed has undershot this target consistently during the Great
Recession. This has lead to a significant debate about the role of targets in deep recessions.
Does communicating a target matter, independent of the central banks actions to reach it?
And doesor shouldmissing a target imply that the miss will later be made up for by
missing in the opposite direction?

There are several arguments why the Federal Reserve hasnt been able to hit its target.
The first is institutional. The Fed, by its nature, will be cautious and place too big a weight
on inflation versus full employment. Many have noted that Ben Bernanke as an academic
described Japan as being in a state of self-induced paralysis (Bernanke 2000). Bernanke
argued that certain actions, such as setting long-term interest rates, establishing a 3 to 4
percent inflation target, creating money-financed fiscal expansion, or executing currency
depreciation, mean that a central bank retains tools even at the zero lower bound. These
more aggressive actions do not characterize Bernankes own tenure, however. Some point
to his tenure on the Board of Governors as a period in which Bernanke moderated his more
aggressive earlier stances (Ball 2012).

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This problem was anticipated by economists like Paul Krugman, who argued that in a deep
recession, it would help for the central bank to credibly promise to be irresponsible, but
will face difficulty due to the conservative nature of central banks. Such a promise may not
be possible in the current institutional setting. The central banker will face great difficulty
doing this because it is inherently a conservative institutionan irrational fear of inflation
has even been considered a desirable quality of central banks, and this cant be turned off
when it is no longer helpful (Krugman 1998). More generally, the fact that the central bank
has already made various explicit or implicit promises in the past, limits its ability to make
new promises now.

This institutional conservatism was reflected in earlier discussions of whether or not

the Fed would make up a period of low inflation by tolerating higher inflation (Jonas
et al. 2003). Some academics argued that policy should opportunistically lock-in
disinflation during such periods when inflation is lower than anticipated (Haldane 1998).
Others emphasized that central bankers should place too large of a weight on inflation
stabilization, and thus systematically bias away from full employment (Rogoff 1985). All of
these threads in inflation targeting led many to worry that the inflation target was a ceiling,
rather than a target where the errors would be symmetric around the 2 percent target. As we
can see from Figure 2, there has been no period since the Great Recession where inflation
was consistently above target.

The Fed tried to demonstrate that they did not see the 2 percent inflation target as a ceiling
during the Great Recession. In December 2012, the Federal Reserve announced a policy
modeled on the Evans Rulenamed for Federal Reserve Bank of Chicago President Charles
Evansthat stated rates would remain at zero even if inflation went above 2 percent, to
a rate of 2.5 percent inflation. It also announced QE purchases that were open-ended,
modeled on criticism of the Feds earlier forward guidance of future rate changes (Evans et
al. 2012; Woodford 2012).

However, throughout 2013, inflation fell to some of its lowest rates. Inflation expectations
were also falling during this time. It is not clear why this happened, but it appears a simple
commitment to a symmetric target with action behind it isnt sufficient to set inflation
expectations.

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 MARKET INTEREST RATES DONT ALWAYS FOLLOW THE FED

10%
8%
6%
4%
2%
0% Policy Rate Baa Corporate Bond 10-Year Treasury Bond 30-Year Mortgage

1995 2000 2005 2010 2015

FIGURE 3 Changes in the Feds policy rate (black) do not always led to proportionate change in the longer interest rates
that matter most for the economy. For instance, when the Fed increased the federal funds rate by 4 points between 2004
and 2006, interest rates on corporate bonds, home mortgages and 10-year federal bonds all increased by less than one
point. Source: Moodys (Baa corporate bond), Board of Governors of the Federal Reserve System (other rates); retrieved
from FRED, Federal Reserve Bank of St. Louis, October 30, 2017

The second explanation for why the Fed has consistently missed its inflation target is
economic. The standard interest rate instrument is paralyzed by the zero lower bound, QE
remains too weak to play more than a supporting role in macroeconomic stabilization, and
expectations of more expansionary policy in the future dont drive private sector decision-
making on investment and spending today. Even positive assessments of QEs impact are
underwhelming. Gagnon (2016) summarizes the results of 16 studies of QE. The median
estimate is that purchases of bonds equal to 10 percent of GDP would reduce long rates by
eight tenths of a pointnot trivial, but quite small relative to the programs size.

As shown in Figure 3, between July 2007 and December 2008, the target federal funds rate
was reduced from 5.25 percent to zero, where it remained until the end of 2015. Yet at the

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end of this extraordinary seven-year period of zero rates, the rate on Baa corporate bondsa
good gauge of the interest rate faced by established businessesfell by only about one point,
from around 6.5 to 5.5 percent. Mortgage rates fell by more, but this is the exception that
proves the rulemortgage lending was precisely an area where the Fed intervened directly
and did not simply rely on overnight rate changes being passed through to market rates.
Most studies find only a modest response of private investment to interest rate changes
(Bernanke and Gertler 1995). It is hard to see how single interest rate changes that are
passed through so weakly to market rates can be relied on to stabilize the economy, even less
to do so fast enough to respond to business-cycle shifts.

WHAT IF WE CHANGE THE FEDS TARGET?

There are certainly good arguments for relaxing the single focus on low inflation that has
guided central banks in theoryif not always in practicefor the past 20 or 30 years. For
one thing, the notion of a single explicit inflation target is relatively new in the history of
central banking. Historically, it is clear that central banks have functioned successfully
without an explicit target for inflation, or with inflation as just one macroeconomic goal
among others. Even if the single inflation target is retained, there is a case that it should be
higher than 2 percent. In an environment where the zero lower bound is a constraint on
monetary policy, a higher inflation target would open more space for conventional policy.

Higher inflation would also reduce the burden of existing debt. Historically, the rise and fall in
inflation have played a larger role in the evolution of both public and private debt than is often
recognized. And in an environment in which inflation expectations are firmly anchored, there
may be a significant tradeoff between inflation and unemploymentperhaps not a permanent
or reliable tradeoff, but one significant enough that policy should take it into account
(Blanchard 2016). There is also an issue, relevant to the current debate, that announcing a
higher or different target would give the Federal Reserve latitude to allow the economy to
return to something closer to the pre-Recession trend linean opportunity that may be difficult
at just 2 percent. A higher inflation target would also eliminate the concern that 2 percent is
actually functioning as a ceiling. So, there are good reasons for the Fed to accept higher inflation
as a goal of policy, either directly or via an alternative target, like the price level or NGDP.

It is one thing to say that higher inflation (or some other target) describes a desirable
outcome. It is something else to say that adopting a different target would in and of itself do
anything to improve the poor economic performance of the past decade or strengthen the
Feds ability to deal with a future downturn. Despite the claims of some proponents, there
are good reasons to doubt that the choice alone of a target has any important effects on the
economy, or that the current inflation target is the main problem with monetary policy today.

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The obvious first problem with framing the issue in terms of targets is that the Fed, like most
other central banks, is not hitting the target it already has. Given that inflation has fallen
short of the Feds 2 percent target for almost a decade now, it is not clear that they would be
more successful at hitting a different target. To be sure, it is easy to imagine a situation in
which stable inflation required, say, a negative 3 percent real interest rate. In this case, the
Fed would be able to hit a 3 percent inflation target (with the nominal rate at zero, the real
rate would be negative 3 percent) but unable to consistently hit a 2 percent inflation target
(with nominal rates at zero, the real rate would still be too high). But this argument only
tells us that conventional monetary policy may be more effective at maintaining a stable
inflation rate when inflation is already higher than it is today; it doesnt give us any reason to
think that the Fed simply announcing a hope for higher inflation will have any real effects.

In addition, many of the proposed targets face substantial challenges in implementation.

For example, one problem with NGDP targetingtechnical but not trivialis that GDP data
are revised regularly in each of the two months following initial release, and are adjusted
more comprehensively every few years. The average revision of initial nominal GDP data
is 0.5 percent in the following month and 1.3 percent by the final comprehensive revision.2
While not huge, these revisions are large enough to create significant problems for policy
that has to be carried out in real time (Posen 2013).

COULD FORWARD GUIDANCE ALLOW FUTURE

POLICY TO AFFECT THE ECONOMY TODAY?
Another solution to the weakness of conventional monetary policy is to try to use future
policywhich presumably will not be constrained by the zero lower boundto influence
economic conditions today. In various forms, this is known as forward guidance.3 New targets
and forward guidance are complementary, since the short-term effectiveness of new targets
largely rests on market participants beliefs about what the targets imply for future policy.

Doubts about the effectiveness of announcing a new target are reinforced by evidence of
central bank experiments with forward guidance. A number of countriesincluding New
Zealand, Canada, Norway, Sweden, and Japan, as well as the United Stateshave seen
central banks experiment with explicit statements about policy actions years into the
future, as a way of influencing financial markets today. Empirical evidence to date suggests
that this had limited effects on financial markets, failing to consistently move interest rates

See Comparisons of Revision of GDP (Bureau of Economic Analysis 2016).

2

Discussions of forward guidance often distinguish between Delphic forward guidance, in which the central bank simply
3

communicates some belief about policy that is likely to be in the future, and Odyssean forward guidance, in which the
central bank somehow or another commits itself to specific future policy choices.

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or asset prices. Nor did it appear to improve market participants ability to predict future
policy (Kool and Thornton 2015). Conversely, the Bank of England, which declined to make
statements about future policy, appears to have achieved comparable results from QE as
central banks that gave extensive forward guidance (Posen 2013). Empirically, what central
banks actually do appears to matter more than what they say they are going to do.

What central banks actually do appears to matter

more than what they say they are going to do.

More generally, there are several good reasons to doubt the effectiveness of announcing
future policy actions as a tool for influencing the economy today. First, economic behavior
is not as forward-looking as this approach requires. For the past generation, most academic
macroeconomics has been based on models of intertemporal optimization by rational
agents. That is to say, actors in the economy are imagined to make decisions by weighing
outcomes over all future time. Meanwhile, the central bank is assumed to pick a rule once
and for all and to stick with it forever. This means that policy a year or ten years from
today factors into economic behavior just as much as policy today. But one clear lesson of
the past decade is that old Keynesian ideas about financial constraints and conventional
expectations are more realistic descriptions of economic behavior than the intertemporal
optimization of newer models. Real households and businesses cannot spend future income
as easily as current incomethat is, they face financial constraints. And their expectations
of the future are more likely to be extrapolations from recent trends or shared beliefs with
no solid foundation, rather than true reflections of the probabilities of future events. So,
even if central banks could make binding commitments about policy several years from
now, economic actors today would not necessarily respond to them.

Second, central banks cannot in fact make binding commitments to actions several years
from now. Regardless of what todays Federal Open Markets Committee (FMOC) says
about the Feds actions in 2025, actions will in fact be taken by the FOMC in place in that
year, as appointed by elected officials between now and then, and on the basis of economic
data available at that time. No statement by todays FOMC will constrain them. Economic
models that feature permanent policy rules are not useful guides for monetary policy in the
real world.4 It is not possible, legally or practically, for a central bank to set a rule that will be
followed for all time, or even to make a binding commitment for policy actions a year from
now. And it is clear that markets recognize this. As Benjamin Friedman (2014) puts it, the idea

As Bernanke (2017) notes, central banks are not typically unitary actors, but may include participants of diverse views
4

trying to reach compromise in an uncertain environment. This kind of institutional realismrooted, in this case, in first-
hand experienceis unfortunately missing from too many discussions of monetary policy rules.

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that central banks can influence economic outcomes today by announcing policy changes
somewhere in the future is more theological than practical. It is based on theoretical models
in which agents have qualitatively greater knowledge of the future than is available in the
real world, and in which they are able to act freely on this knowledge thanks to the absence of
exactly the kinds of financial frictions that make monetary policy necessary in the first place.

The idea that central banks can influence economic

outcomes today by announcing policy changes
somewhere in the future is more theological
than practical.

WHAT IF WE COULD SET THE INTEREST RATE

BELOW ZERO?
Another policy tool widely discussed in recent years is negative nominal rates. Under current
arrangements, such rates are supposed to be off the table because of the zero lower bound, but it
is clear that this bound is in fact somewhat porous. Several central banks have experimented
with negative interest rate targets, and in a number of countries, especially in Europe, private
markets have moved rates on longer government bonds into negative territory without any
direct action by the central bank. It is not clear how far below zero nominal rates can get without
significant institutional changesone highly-discussed possibility is that moving rates much
more below zero would require the abolition of cash. There are other practical problems with
implementing negative ratesa tax on reserves (the most common suggested approach) might
not be transmitted through to bank deposit and lending rates in the same way as changes in the
overnight rate. There are also concerns that if financial institutions, households, and businesses
do adjust their balance sheets in response to a negative ratethe only way it can be effective
this will create serious problems if and when rates return to positive levels (Palley 2016).

There are many concerns that might be raised about the radical step of eliminating cash
and the impact of negative rates more broadlyon the balance sheets of insurance and
pension funds, for example. But the real problem with proposals for negative rates is that
they are not radical enough. They remain within the orthodox framework in which there
is a single, economy-wide interest rate, which is tightly linked to the rate set by the central

The real problem with proposals for negative rates is

that they are not radical enough.

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bank on one side and to the level of real activity on the other. If the Feds main policy lever
is connected weakly, if at all, to the real economy, then simply allowing that lever to move
further will not be an effective way to stabilize the economy. It is hard to argue that the
extra space provided by negative rates is worth the political and institutional changes
needed to make them possible, especially since negative rates do nothing to address the
broader goals of policy discussed above.

The problem with looking toward negative rates as

the solution to monetary policys weakness is that
there is not a single interest rate, but many interest
rates, many asset markets, and many different kinds
of institutions participating in them.

The problem with looking toward negative rates as the solution to monetary policys
weakness is that there is not a single interest rate, but many interest rates, many asset
markets, and many different kinds of institutions participating in them. A variety of
financial frictions and other institutional features of real-world finance prevent easy
arbitrage between these different markets, so different interest rates, prices of different
assets, and access to credit of different borrowers may move independently. In a 2012
speech, the fundamental issue was described very clearly by Posen:

Differentiation of financial assets matters. One of the most foolish mistakes of the
last 15 years was that we actively assumed this fact away One key lesson is that there
simply is not one real interest rate for the economy. Households are facing one set of
highly differentiated interest rates, small and medium enterprises are facing another set
of far from smoothly distributed interest rates, as is the construction sector, and so on
If the persistence of financial fragility and of weak recovery are in large part due to the
preferred habitats of asset holders with imperfectly substitutable assets, these problems
are not easily addressable by moving the price of one financial asset or the level of one
interest rate.

As we have seen, it is quite possible for the policy interest rate to be extremely low
while credit remains tight for many non-financial firms and households. Rather than
looking for ways to push its old policy instrument farther, the Fed should be looking for
new instruments that operate closer to the sectors of the economy that actually face
credit or liquidity constraints. There is no assurance that liquidity injected in one place
(e.g., through purchases of Treasury bonds) will flow to where it is needed (e.g., small
businesses or underwater homeowners). For policy to be effective, it has to first answer

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the key question: where is the bottleneck in the economy? (Brunnermeier and Sannikov
2013). Otherwise, it is entirely possible that the liquidity created by the central bank will
pile up on the balance sheets of a few favored institutions while the rest of the economy
continues to suffer from inadequate access to credit.

For policy to be effective, it has to first answer

the key question: where is the bottleneck in the
economy? Otherwise, it is entirely possible that
the liquidity created by the central bank will pile up
on the balance sheets of a few favored institutions
while the rest of the economy continues to suffer
from inadequate access to credit.

Absent another major crisis, the Fed is unlikely to give up its framework based on an
aggregate target and a short-term interest rate as the main instrument of policy. So
it is important to think about better rules within that framework for sustaining full
employment. But, given the weak track record of meeting its targets in the Great Recession
and aftermath, and the economic and institutional barriers to rely on the short-run policy
rate in future downturns, we also need to look beyond that framework. The remainder of
this paper lays out some directions to explore.

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SECTION THREE

A New Direction for Monetary Policy

The most important change that would improve the ability of the Fed to prevent severe
downturns and maintain full employment is conceptual: The central bank needs to accept
its responsibility for actively directing credit to particular end uses and abandon the
idea that macroeconomic management can be carried out by setting one interest rate or
any other single, economy-wide variable. Active credit policy is necessary to ensure that
liquidity flows to productive, demand-boosting investment and not to asset speculation and
unproductive borrowing; to allow the Fed to address distributional and other targets, as well
as the level of aggregate demand; and simply to ensure that policy changes actually have
traction on the real economy.

The central bank needs to accept its responsibility for

actively directing credit to particular end uses and
abandon the idea that macroeconomic management
can be carried out by setting one interest rate or any
other single, economy-wide variable. Active credit
policy is necessary to ensure that liquidity flows to
productive, demand-boosting investment and not to
asset speculation and unproductive borrowing.

As the start of what we hope will be a larger conversation, we propose the following six
changes in central bank practices. Some of these describe choices that the Fed can already
make under its existing authority. Others may require action by a broader set of policymakers.

1. Setting long-term interest rates

2. Increasing support for public borrowing

3. Purchasing state and local debt

4. Coordinating Treasury and Federal Reserve policy

5. Purchasing a greater range of private debt

6. Shifting from a monetary policy to a credit policy framework

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1. SETTING LONG-TERM INTEREST RATES
Following the example set by the Bank of Japan (BOJ), the Fed should target long-term
interest rates in addition to the overnight rate, which is the current focus of monetary
policy. This is a natural extension of the current monetary policy framework. Unlike
many other reforms, it would require no change in either the Feds statutory authority
or its operating procedures. It would simply be a modification of existing quantitative
easing where, instead of announcing the quantity of bonds to be purchased, the Fed would
announce a target price for them.5

The Fed should target long-term interest rates in

addition to the overnight rate, which is the current
focus of monetary policy. This is a natural extension
of the current monetary policy framework. Unlike
many other reforms, it would require no change in
either the Feds statutory authority or its operating
procedures. It would simply be a modification of
existing quantitative easing where, instead of
announcing the quantity of bonds to be purchased,
the Fed would announce a target price for them.

Currently, quantitative easing works by setting the quantity of purchases of long-term debt.
Starting in December 2012, for instance, the Fed started buying $45 billion a month of long-
term treasuries in an open-ended commitment. This was the third, and most aggressive,
version of purchases, generally referred to as QE3. This method was chosen as a way to
push down longer interest rates and boost the economy. But what if, instead of targeting an
amount, QE worked by targeting a price?

The BOJ introduced this strategy in September 2016, under the name yield curve control.
This is an intervention where the BOJ will control short-term and long-term interest
rates. They stated that the initial target was to intervene so that 10-year [Japanese
government bond (JGB)] yields will remain more or less at the current level (around zero
percent) (Bank of Japan 2016). There are already several positive signs that show its
superiority over targeting the quantity.

Since the price and yield of a bond vary inversely, fixing the price of, say, 10-year Treasury bonds, is the same as fixing
5

the interest rate on them.

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The first sign is straightforward: a reduction in the volatility of rates. Figure 4 compares JGB
yield movements in 2016-2017 to U.S. treasuries following the implementation of QE3 in 2013.

BOJ SHOWS BETTER CONTROL OF RATES THAN QE IN THE U.S.

Japanese 10-Year Interest Rates US Treasuries 10-Year Rates

Period of BOJ Rate Control Period of QE3
6
5
4
3
2

Period of
BOJ Rate
Period of QE3 Control
1
0
-1

1/1/2010
4/1/2010
7/1/2010
10/1/2010
1/1/2011
4/1/2011
7/1/2011
10/1/2011
1/1/2012
4/1/2012
7/1/2012
10/1/2012
1/1/2013
4/1/2013
7/1/2013
10/1/2013
1/1/2014
4/1/2014
7/1/2014
10/1/2014
1/1/2015
4/1/2015
7/1/2015
10/1/2015
1/1/2016
4/1/2016
7/1/2016
10/1/2016
1/1/2017
4/1/2017
7/1/2017
1/1/2007
4/1/2007
7/1/2007
10/1/2007
1/1/2008
4/1/2008
7/1/2008
10/1/2008
1/1/2009
4/1/2009
7/1/2009
10/1/2009

FIGURE 4 Source: St. Louis Fed, FRED Economic Data: https://fred.stlouisfed.org/series/GS10

As the figure shows, the JGB remains flat during this time period. Treasuries, however,
fluctuate widely. Future Roosevelt Institute work will quantify these changes further. But
to start, the volatility of both monthly JGB values and returns drop by half from the year
before the announcement to the year after. For 10-year Treasuries, the volatility actually
increased in the year after QE3 was announced, compared to the year before.

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One reason treasuries fluctuated more was because it was difficult to read and understand
the various concerns Federal Reserve officials were raising about the purchases. When
officials discussed changing the dates on the purchases, this forward guidance created
confusion regarding the ultimate goals of monetary policy.

A second benefit of the price target was that the BOJ has had to purchase fewer assets to achieve
the same rate reduction. In the second quarter of 2017, the BOJ purchased 13.5 trillion yen of
bonds, compared to 22.3 trillion yen during the same time in 2016. As can be seen from Figure
5, the price target allowed the BOJ to purchase fewer assets while keeping markets more stable.
This is an important advantage over traditional QE, where both the public and policymakers
hesitate over the necessary increases in the size of the central banks balance sheet.

SETTING RATES HAS ALLOWED FOR REDUCED BOJ PURCHASES

Purchases by the Bank of Japan, 100M Yen, Quarterly

300k

250k

200k

150k

100k

50k

-50k 9/1/2016
11/1/2016
9/1/2013
11/1/2013
1/1/2014
3/1/2014
5/1/2014
7/1/2014
9/1/2014
11/1/2014
1/1/2015
3/1/2015
5/1/2015
7/1/2015
9/1/2015
11/1/2015
1/1/2016
3/1/2016
5/1/2016
7/1/2016

1/1/2017
3/1/2017
5/1/2017
7/1/2017
7/1/2010
9/1/2010
11/1/2010
1/1/2011
3/1/2011
5/1/2011
7/1/2011
9/1/2011
11/1/2011
1/1/2012
3/1/2012
5/1/2012
7/1/2012
9/1/2012
11/1/2012
1/1/2013
3/1/2013
5/1/2013
7/1/2013

FIGURE 5 Source: St. Louis Fed, FRED Economic Data: https://fred.stlouisfed.org/series/JPNASSETS

The smaller required purchases are a direct result of the announcement of a target for
the long rate. When rates began to rise towards 0.10 percent, the BOJ took action to
communicate that it would buy an unlimited amount to keep rates from going above that.
As Grant Lewis, head of research at Daiwa Capital Markets Europe, told The Wall Street
Journal, the BOJ stood up and said yields will be held at these levels. Try and beat me, Ive
got infinite resources. Thats actually allowed them to start purchasing less (Bird 2017).

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This is important going forward. Along with greatly increasing both the size and the scope
of their balance sheets, one of the main new tools central banks have adopted in the wake
of the 2007-2009 crisis is forward guidance about future policy and future targets for
macroeconomic aggregatesannouncing, for instance, a willingness to accept higher
inflation for some period in the future (Friedman 2014). While shifting expectations of
future policy may be a powerful tool in formal models, it is unlikely to be an effective or
reliable tool in real life.

Announcements of future targets for macroeconomic variables are unlikely to be accepted

at face value when the central bank is failing to meet its existing targets, as is the case
today and is likely to be the case in any situation where unconventional policy is called for.
And, as we discussed in Section II, announcements of future policy are not meaningful
since future authoritiesappointed by future presidentswill be free to ignore them.
But the limited effectiveness of forward guidance doesnt mean that all central bank
communication is impotent.

Announcements of future policy can have a powerful effect when a central bank announces
a target price in a market in which it is currently active, and in which it has the demonstrable
power to move prices. If the Fed announces that it will buy, lets say, 10-year Treasuries until
their price rises to a certain level, the significance of this statement doesnt depend on either
counterfactual assumptions about the Feds ability to move macroeconomic aggregates or
the behavior of future bank authorities. And, given the credibility of the promise in this case,
it would be irrational for market participants to sell the bonds at any price below the Feds
target. As this example shows, announcing the goal of the intervention greatly reduces
perhaps almost to zerothe amount that the Fed actually has to buy or sell. As Bernanke
(2017) puts it, A yield target may be enforceable with reduced quantities of purchases by
the central bank [compared with QE], because deviations from the target will be arbitraged
away by market participants. This is why yield curve control, such as adopted in Japan, may
allow the central bank to produce large changes in market interest rates with only small
volumes of transactions.

While the Japanese experiment is still in its early days, there are good reasons to believe
that the arbitrage described by Bernanke is effective. In the decades before 2007, the Fed
and other central banks set overnight interest rateslinked to an immense volume of
lending between financial institutionswith a comparatively tiny volume of transactions in
the federal funds market. This was effective because once the Fed announced a target rate,
private institutions had every incentive to quickly adopt that rate in their own transactions.
Its worth noting that before the mid-1980s, open-market operations were conducted
similar to how QE is today, with the Fed simply buying or selling a certain quantity of
securities. The practice of announcing a target rate was adopted precisely because it

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gave the Fed much more control over market rates with a much smaller volume of actual
transactions (Kripper 2011, p. 122-128). Going back further to World War II, the Fed, like
many central banks, pegged the rate on longer-maturity government bonds (at 2.5 percent,
in this case). The Fed had no trouble maintaining their target rate without the need for
excessively large purchases or sales (Eichengreen and Garber 1991).

2. INCREASING SUPPORT FOR PUBLIC BORROWING

One of the most widely discussed alternatives to conventional monetary policy is
helicopter money. While this term has been used to refer to a number of different
activities, one main usage is direct central bank funding of fiscal expansion. In effect, the
government increases public spending in the usual way, but instead of issuing bonds to the
public to pay for it, the government issues the bonds directly to the monetary authority,
which purchases them with newly created money.

In effect, the government increases public spending

in the usual way, but instead of issuing bonds to the
public to pay for it, the government issues the bonds
directly to the monetary authority, which purchases
them with newly created money.

While the merits of this policy have been extensively debated, the extent to which current U.S.
policy already looks like this is much less widely recognized. Between 2010 and 2016, the Fed
increased its holdings of Treasury debt by nearly $2 trillion. This represents approximately
30 percent of total federal borrowing during this period. In other words, while economists
debate the theoretical merits of helicopter money, it has already been in substantial use.

The reason that this extraordinary shift toward monetary finance of public spending
has received so little attention is that the policy has never been described as such. What
quantitative easing actually consists of, is large central bank purchases of public debt, or
in other words, central bank loans to the federal government. It follows that, if the federal
government faces any kind of financial constraints, QE must have gone a long way to
removing them. (There is no need to worry about how much federal debt the bond markets
will buy if the Fed is actually buying it.)

This has never been described as the goal of the policy. Rather, its described as a roundabout
way of influencing the willingness of the financial system to hold private liabilities. Whats

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being eased are credit conditions for private borrowers. Whatever reduction QE produces
in interest rates on government debt is just a way of reducing rates on private debt. In the
language of Borio and Disyatat (2010), QE is always described as credit policy rather than
debt-management policy.

The Fed should be explicit about support for public

borrowing, encouraging the government to employ
countercyclical fiscal policy along with monetary
policy. In other words, quantitative easing should be
frankly described as what it is: monetary finance of
public spending.

We propose that the Fed should be explicit about support for public borrowing, encouraging
the government to employ countercyclical fiscal policy along with monetary policy. In
other words, quantitative easing should be frankly described as what it is: monetary finance
of public spending. Such a change in language would have major benefits, even if the
substantive policy did not change. By clarifying that its policy is, in fact, one of supporting
the market for government debt, the Fed would assuage any doubts about the sustainability
of public finances. This alone would have a stabilizing effect on bond markets and might well
lead to lower long ratesthe ultimate goal of the policy. Perhaps, more importantly, it would
reassure policymakers in the elected branches and clarify discussions of budget questions.
One simple step in this direction would be to exclude federal debt held by the Fed from
headline measures of government debt.

3. PURCHASING STATE AND LOCAL DEBT

Unlike the federal government, state and local governments do face meaningful financial
constraints. Perhaps the single most powerful tool the Fed has to support aggregate demand
and direct credit in socially useful directions is to purchase the liabilities of states, cities,
and other subnational governments. This would greatly reduce the pressure for pro-cyclical
cuts in public spending during recessions.

Perhaps the single most powerful tool the Fed has

to support aggregate demand and direct credit in
socially useful directions is to purchase the liabilities
of states, cities, and other subnational governments.

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The balance sheets of state and local governments are complexunlike the federal
government, most have substantial financial assets, as well as liabilities, and the sector as a
whole is a net creditor (Mason, Jayadev, and Page Hoongrajok 2017). But many individual
governments do face acute limits on their access to credit, and concerns over credit are
a constraint on spending and revenue decisions, even if their access to bond markets is
currently unimpaired. These concerns become especially serious during downturns
exactly the period when, from a macroeconomic perspective, state and local governments
should be increasing spending and avoiding tax increases.

From a social standpoint, public investment is less costly during a downturn, when a larger
fraction of labor and other resources are unemployed. So it is perverse that borrowing
constraints cause many governments to cut back investment spending in recessions.

FALLING STATE AND LOCAL SPENDING HAS CONTRIBUTED TO THE WEAK RECOVERY
15.5

Total Spending
Percent of GDP

15.0

2002-2007 Average
14.5
14.0
2.4
Percent of GDP

2002-2007 Average
2.2

Investment Spending
2.0
1.8

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

FIGURE 6 Both total spending and investment spending by state and local governments declined steeply between 2007
and 2017. This procyclical behavior of state and local government budgets may be due in part to the cost and availability of
credit for these governments. BEA; retrieved from FRED, Federal Reserve Bank of St. Louis, October 30, 2017

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Financial constraints on state and local governments impart a substantial pro-cyclical
component to their budget positions, acting as a kind of automatic destabilizer that offsets
countercyclical fiscal policy at the federal level. In the most recent recession, the state
and local sector did move substantially into deficit in 2009statutory balanced-budget
requirements can be avoided over the short run by shifting payments forward or back in
time and running down reserves. But by 2010, the sector had already moved back to surplus.
While state and local spending did rise during the recession, it fell even more steeply
afterward, and is now about 10 percent lower (as a share of GDP) than it was a decade ago.

As we see from Figure 6, this decline in state and local spending imparted a substantial
contractionary impulse to the economy during a period in which a great majority of
economists and policymakers believed more expansionary policy was needed, and is one
factor in the unusually weak recovery. By purchasing state and local debt, the Fed can
relax these credit constraints, ensuring both that vital services and public investment are
provided by financially constrained governments and that the overall balance of state and
local spending behaves countercyclically rather than pro-cyclically as it does today.

By purchasing state and local debt, the Fed can relax

these credit constraints, ensuring both that vital
services and public investment are provided by
financially constrained governments and that the
overall balance of state and local spending behaves
countercyclically rather than pro-cyclically as it
does today.

In addition to these macroeconomic considerations, certain governments face acute financial

difficulties that can lead to the curtailment or interruption of vital public services independent
of the condition of the national economy. Recent examples of subnational governments
facing acute financing constraints include Detroit and Puerto Rico. While the underlying
causes of these crises are complex, at a high level they represent breakdowns of the normal
arrangements that allow economic units to make payments and promises and set expenditure
independent of current income. As such, they represent financial crises comparable in
severity, though more limited in scope, to the one that the Fed intervened in so aggressively in
2007-2009and they should receive a comparable response from the Fed. It is hard to see why
the failure of AIG or Bear Stearns was not acceptable, but the failure of financially-constrained
governments to deliver basic public services to millions of Americans is.

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 It is hard to see why the failure of AIG or Bear
Stearns was not acceptable, but the failure of
financially-constrained governments to deliver
basic public services to millions of Americans is.

Given the two goals of supporting state and local spending during cyclical downturns
and providing relief for particular governments facing financial distress, the Fed should
develop facilities for purchasing state and local debt. This could involve a standing offer
to purchase state and local debt, up to some amount based on a formula involving average
revenue over recent years, resident population, or similar metrics. Both the interest rate
and quantity of this lending could be varied based on macroeconomic conditions. The
Fed might also make clear that it is ready to make emergency loans above this amount to
particular governments facing acute financial pressure. In order to avoid undermining
democratic government, however, it is important that there be no policy conditionality
attached to such emergency loans.

One obstacle to a program of lending to state and local governments is that the Fed is
currently authorized to buy their debt with a maturity of six months or less. This law should
be changed. But it doesnt represent a major obstacle to a program of Fed purchases of state
and local debt. By committing to roll over the debt for a certain number of years at a fixed
rate, the Fed can effectively lend to state and local governments at the longer maturities
more suited to their needs. Central banks have credibility. Here is a case where that hard-
won credibility can be put to practical use. A Fed announcement that it will roll over short-
term borrowings a fixed number of times at the same interest rate (say, 20 times, to create
the equivalent of a 10-year loan) will be meaningful in a way that an equivalent promise
from a private lender would not be. If such a facility is established, its benefits could greatly
exceed the actual volume of loans made. A public commitment to stabilize the finances of
state and local governments will make them safer borrowers, making it easier for them to
issue conventional bonds in private markets.

Its important to note that increased lending to state and local governments is not always
the right answer to the problem of financial constraints on public spending. In some cases,
outright debt forgiveness may be more appropriate. Puerto Rico may be in that situation
today. In other cases, the answer may be increased federal aid, or even in the long run,
shifting the burden of some kinds of public services from the state or local level to the
federal. In the near term, however, the Fed has a great deal of power to alleviate the acute
financial distress faced by some subnational governments and the pro-cyclical fiscal
behavior of the sector as a whole. This power should not be dismissed.

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4. COORDINATING TREASURY AND
FEDERAL RESERVE POLICY
Alongside an acknowledgement of support for public borrowing, it is important to ensure
that public borrowing doesnt conflict with Federal Reserve policy. An important element
of policymaking at the zero lower bound is the distribution of Treasury debt maturity.
The U.S. debt held by the public has ranged from 25 to 48 percent of GDP from the 1970s
to right before the crisis. Since the crisis, debt has risen to 70 percent of GDP. From a
macroeconomic standpoint, all debt is not equallonger-term Treasury bonds are closer
substitutes for the private debt that finances real activity than are short-term Treasury bills
that the Fed normally deals in.

Its the responsibility of Treasury officials to determine the maturity, or length of

repayment, for Treasury debt. Though orthodox economic theory (the Modigliani-Miller
theorem) implies that market pricing should arbitrage away any major divergence between
rates on debt of different maturities, this is not necessarily true in practice. And even if it
were, there are important second-order effects from uncertainty and changing economic
conditions that accompany the maturity of repayment. The historical average for the
maturity of outstanding debt between 1980 and 2014 was 58.7 months (Treasury 2014).

The maturity level of Treasury debt probably has little macroeconomic effect in normal
times, and conventional monetary policy can usually offset whatever effect Treasury
borrowing choices may have on financial conditions. The Treasury influences the supply of
Treasury debt of different maturities, affecting their different interest rates. But the actions
of the Federal Reserve should be able to move the whole complex of interest rates together.
In theory, if the short-term rate rises, it should move longer-term interest rates up with it,
and if the short-term interest rate falls, it should pull longer-term rates down. In practice,
as discussed above, the links between shorter- and longer-term rates are not as tight as
orthodox theory suggests. But even if they are linked, this is not helpful when short-term
rates themselves are stuck at zero. In this case, further expansion must focus on the longer
end, where Treasury choices about the maturity structure of debt are likely to matter more.

Since the 1980s, theres been little or no coordination between Treasury and Federal
Reserve officials. The U.S. Treasury has handled decisions about the maturity of the
debt, thinking through stability, market needs, and uncertainty surrounding economic
policymaking. They do not take under consideration macroeconomic effects. That
responsibility has fallen to the Federal Reserve, which sets the interest rates with an eye
towards full employment and inflation.

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However, since the Great Recession, with interest rates at the zero lower bound, these two
roles have become blurred. QE, in particular, sets up these two goals to be potentially in
conflict. An important channel through which QE works is shortening the maturities of debt
available to private market actors. As Janet Yellen has argued, central bank purchases of
longer-term securities work through a portfolio balance channel to depress term premiums
and longer-term interest rates (Yellen 2011). Or, as Ben Bernanke has argued, changes in
the supplies of various assets available to private investors may affect the prices and yields
of those assets [...] Declining yields and rising asset prices ease overall financial conditions
and stimulate economic activity (Bernanke 2012). But if the Treasury is meanwhile trying
to issue more longer debt, this effect will be canceled out.

Instead of coordinating during the Great Recession, Treasury and Federal Reserve officials
pulled in opposite directions. As can be seen from Figure 7, the Treasury lengthened the
average maturity above the historical range at exactly the moment in which the Federal
Reserve was trying to reduce term premiums and long-term interest rates.

TREASURY DEBT MATURITY INCREASES, OFFSETTING QE

75
70
Average Maturity of Treasuries (months)

65
60
55
50
45
40
1/1/00
6/1/00
11/1/00
4/1/01
9/1/01
2/1/02
7/1/02
12/1/02
5/1/03
10/1/03
3/1/04
8/1/04
1/1/05
6/1/05
11/1/05
4/1/06
9/1/06
2/1/07
7/1/07
12/1/07
5/1/08
10/1/08
3/1/09
8/1/09
1/1/10
6/1/10
11/1/10
4/1/11
9/1/11
2/1/12
7/1/12
12/1/12
5/1/13
10/1/13
3/1/14
8/1/14
1/1/15
6/1/15
11/1/15
4/1/16
9/1/16
2/1/17
7/1/17

FIGURE 7 U.S. Department of the Treasury, Most Recent Quarterly Refunding Documents: https://www.treasury.gov/
resource-center/data-chart-center/quarterly-refunding/Pages/Latest.aspx

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One influential estimate found that these considerations likely offset a third of the stimulative
efforts of QE (Greenwood 2014). This is a substantial offset given the nature of monetary policy
at the zero lower bound. Worse, it is one area where Federal Reserve and Treasury officials
have not signaled that they are reconsidering their policy in light of the Great Recession.

This is not new policy. During the 1960s, Treasury

and Federal Reserve officials coordinated in
Operation Twist, an effort to lower long-term
rates while leaving short-term rates unchanged.

There are numerous options for coordination. A simple one, suggested by Greenwood and
others, is for both the Treasury and the Fed to release joint statements on their plans for
the maturity structure of Treasury debt. This would make the decision-making explicit
and force both sides to consider each others objectives. The Federal Reserve would have to
understand the fiscal risks that the Treasury understands itself to face, and the Treasury, in
turn, would understand the macroeconomic conditions that the Federal Reserve works to
navigate. As a baseline, this would align both sides with having to create a determined plan.
But given that the Treasury department will be setting maturity, it is impossible for them
not to be providing support or a headwind to zero lower bound policy.

This is not a new policy. During the 1960s, Treasury and Federal Reserve officials
coordinated in Operation Twist, an effort to lower long-term rates while leaving short-
term rates unchanged. Due to the Bretton Woods fixed exchange rate system, policymakers
were worried about international gold flows that might result from changes in short-term
interest rates. Recent research has found that Operation Twist was successful in reducing
long-term Treasury yields by about 0.15 points (Alon 2011).

5. PURCHASING A GREATER RANGE

OF PRIVATE DEBT
The widespread belief that low interest rates create a danger of excessive borrowing and asset
bubbles is itself a strong argument that the private financial markets do not, in fact, channel
liquidity in socially desirable directions, and that these types of programs are needed.

Purchasing a broader range of private liabilities may also be necessary simply to make the
transmission of routine monetary policy more reliable. While simple economic models refer to
the interest rate, in fact there are many interest rates in the economy. Monetary policy that

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operates on the market for overnight loans between banks (as in the decades before 2007) or
the market for federal debt (as in the post-2007 quantitative easing programs) is not directly
affecting longer-term rates for private borrowers. But it is precisely these rates that matter
for aggregate demand (Stiglitz 2013). If the various rates all moved together, this would not be
a problem. But in fact, the various rates do not move in unisonlowering the overnight rate
often simply leads to wider spreads, with longer market rates unaffected (Mason and Jayadev
2015). If we expect the Fed to stabilize demand by shifting interest rates, it will need to operate
on a wider range of rates directly, and not simply assume that the whole structure will move in
unison. In addition, not all activity is equally sensitive to changes in interest rates. Purchasing
the debt of smaller firms in selected sectors not only allows the Fed to channel credit to socially
useful activity, it makes it more likely that changes in monetary policy will actually reach the
credit-constrained businesses and households whose behavior is most likely to be affected.

If we expect the Fed to stabilize demand by shifting

interest rates, it will need to operate on a wider range
of rates directly, and not simply assume that the
whole structure will move in unison.

During the crisis, the Fed acquired very large holdings of mortgage-backed securities
(MBSs). The Fed has followed a policy of maintaining these holdings since the crisis,
purchasing an equal volume of new ones as its existing mortgage-backed securities mature.
In recent years, these purchases have amounted to about $30 billion a month, or about
15 percent of total new mortgages issued in the country. (This is down from $60 billion a
month in 2013-2014, the majority of new mortgage backed securities issued during that
period.) These purchases were originally undertaken not to support the mortgage market
but to revive interbank lending by removing toxic assetsMBSs of uncertain valuefrom
bank balance sheets. But the ongoing purchases have also provided support for the market
for MBSs, making issuing of new mortgages more attractive to banks. This has made an
important contribution to the revival of housing lending since the crisis.

While promoting homeownership is a longstanding goal of monetary policy, home

mortgages are far from the only form of lending that serves a socially important goal and
that may be underprovided for by private markets. Rather than winding down its purchases
of mortgage-backed securities, as currently proposed, the Fed should extend these
purchases to other classes of securities. In particular, the Fed should purchase debt issued to
finance investments that address climate change, including the development of non-carbon
energy sources and building retrofits to reduce energy use.

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During the financial crisis of 2007-2009, the Fed created special facilities to support lending
in a range of other markets. To support markets for securitized auto loans and credit card
loans, the Fed created the Term Asset-Backed Securities Loan Facility (TALF) in November
2008, which purchased nearly $50 billion of such securities. The Fed also created lending
facilities to provide support to commercial paper, money-market funds, and securities
broker-dealers (Price 2012). While conceived of as emergency measures, similar programs
could be adopted on an ongoing basis if there is reason to believe that the normal allocation
of credit is inconsistent with social priorities, or with financial stability, or with the Feds
other macroeconomic objectives.

Similar programs, like the TALF, could be adopted

on an ongoing basis if there is reason to believe that
the normal allocation of credit is inconsistent with
social priorities, or with financial stability, or with
the Feds other macroeconomic objectives.

At present, the Fed is more limited than most central banks in the types of assets it can
purchase. Direct lending to non-financial businesses or households might require new
legislation. On the other hand, when the Fed has felt forced to act in a crisis, the legal
restrictions on its activities have often turned out to be quite elastic. In any case, it is
important to have leadership at the Fed that is willing to push its existing authority as far as
possible to channel credit toward socially useful activities. Future Fed appointees should be
encouraged to adopt an expansive view of their ability to supportdirectly or indirectlya
broad range of private and public debt markets.

It is important to have leadership at the Fed that is

willing to push its existing authority as far as
possible to channel credit toward socially useful
activities. Future Fed appointees should be
encouraged to adopt an expansive view of their
ability to supportdirectly or indirectlya broad
range of private and public debt markets.

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6. SHIFTING FROM A MONETARY POLICY TO
A CREDIT POLICY FRAMEWORK
In the long run, making the Fed a more reliable steward of the macroeconomy is not
just a matter of adopting this new instrument or that new target. It will require a
reconceptualization of the Feds place in the financial system. The clean separation of
monetary policy, carried out by an independent central bank based on a simple policy
rule, from other aspects of macroeconomic policy conducted by the elected government,
is no longer viableif indeed it ever was. While the Fed must adopt a broader view of its
responsibilities, Congress also must take action in areas that were traditionally delegated to
the central bank.

While the Fed must adopt a broader view of its

responsibilities, Congress also must take action
in areas that were traditionally delegated to the
central bank.

It is clear that an environment of abundant liquidity is no guarantee that activities with

high social or even private returns will be adequately financed. Many small and medium
enterprises may have promising projects but are unable to obtain financing because of
information asymmetries or other market failures. Similarly, some households may be
excluded from credit markets because of reasons like low current income, while other
households may be encouraged to borrow excessively. Recent empirical research on credit
markets has documented how partitioned they are, with various asset prices and interest
rates moving quite independently based on factors in their own narrow markets. Even
if aggregate liquidity or average interest could be reliably set at the right level, many
individual borrowers would still get too little credit, and a few would get too much. As
Stiglitz (2013) puts it, Governments and central banks need to have explicit programs to
encourage lending to certain groups/sectors that are underserved. This calls for a shift both
in how Fed officials think of their own role, and in how Congress thinks ofand legislates
forthe Fed and the private financial system.

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THE ROLE OF LEGISLATION
The Federal Reserve cannot bear sole responsibility for macroeconomic stability and social
consequences of credit creation. The federal government must also take a bigger role in
the direction of credit. The federal government already devotes substantial resources to
creating, directing, and facilitating credit. The federal government has $1.24 trillion in
direct loan programs and $2.37 trillion in loans it guarantees (OMB 2017). Table 1 shows
some of the major programs:

ESTIMATED FUTURE COST OF OUTSTANDING DIRECT LOANS AND LOAN GUARANTEES

Programs Outstanding in 2015 (In billions of dollars)

FHA Mortgage Insurance 1,123

Federal Student Loans 839

VA Mortgages 462

Student Loan Guarantees 220

FHA General and Special Risk Insurance Fund 149

TABLE 1 Source: Office of Management and Budget, Budget of the U.S. Government, Fiscal Year 2018.

The Federal Reserve cannot bear sole responsibility

for macroeconomic stability and social consequences
of credit creation. The federal government must also
take a bigger role in the direction of credit.

These major credit programs are centered around both student loans and mortgages
through the Federal Housing Administration (FHA), each representing more than a trillion
dollars of loans. Other notable programs reflect transportation infrastructure financing,
disaster assistance, small business loans, and the Export-Import Bank.

As private credit collapsed during the financial crisis and early Great Recession, particularly
in the mortgage market, these programs increased in size. We see the importance of these
policies most clearly in the mortgage market. In the immediate aftermath of the Great
Recession, the federal government took over most of the housing mortgage market. The
government-sponsored enterprises of Fannie Mae and Freddie Mac were taken directly
on the government books. FHA, in particular, took on a countercyclical role in the Great

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Recession. It backed more than 4 million mortgages in 2008. If the FHA was not active
in 2011, according to one set of estimates, mortgage interest rates would have more than
doubled and new housing construction would have fallen by more than 60 percent. Moodys
estimates found that if the FHA had not been active, GDP would have declined by an
additional 2 percent (Griffith 2012).

Government policies designed to encourage refinancing also played a role in

macroeconomic policy. At the end of 2011, for example, 22.8 percent of residential
properties with a mortgage had negative equity in the property. These mortgages are
referred to as underwater in the mortgage markets, and 22.8 percent translated to 11.1
million properties. This represented $2.8 trillion in negative equity. Known as near-negative
equity, an additional 2.5 million properties had less than 5 percent equity. In total, 27.1
percent of residential properties with mortgages had negative equity (Campbell 2011).

If the FHA was not active in 2011, according to one

set of estimates, mortgage interest rates would have
more than doubled and new housing construction
would have fallen by more than 60 percent. Moodys
estimates found that if the FHA had not been active,
GDP would have declined by an additional 2 percent.

Empirical and theoretical work from the Great Recession emphasized the contractionary
results of so much negative equity. Facing binding leverage constraints resulting from the
collapse in home value, consumers began deleveraging by rapidly paying down debts. Pre-
2007 consensus would expect this behavior to result in lower interest rates to maintain full
employment, yet the zero lower bound was already binding. The theoretical work shows that
this can drive down aggregate demand and keep an economy away from full employment
(Eggertsson 2010). The empirical results found that areas with higher negative equity
suffered significantly worse unemployment. This unemployment couldnt be explained
simply by a mismatch of skills or by a negative shock to wealth (Dynan 2012; IMF 2012;
Mian 2012 and Mian 2013).

Refinancing at lower interest rates is one way to address this. However, underwater and near-
negative equity homes usually cant refinance in traditional ways. During the financial crisis,
policymakers addressed this through coordination between the Treasury and the Federal
Housing Finance Agency (FHFA), which oversees mortgages owned or guaranteed by Fannie
Mae and Freddie Mac in a program called the Home Affordable Refinance Program (HARP).

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When launched in 2009, Treasury and FHFA officials estimated that 4 to 5 million
homeowners would refinance through the program. Through 2011, however, only 1 million
did. After a substantial reworking of the program, 2.4 million homeowners refinanced
between 2012 and 2013 (FHFA 2013). Had this program been executed both earlier and
more aggressively, more families could have avoided foreclosure and more could have been
done to stabilize demand and secure family balance sheets, creating a macroeconomic
benefit for everyone.

Taken together, the overall credit portfolio played a large role in countercyclical policy
during the Great Recession. One estimate found that the stimulative effect of federal
credit programs was close to $400 billion in 2010 (Lucas 2016). If future recessions occur
alongside failures in financial markets that make it difficult to translate macroeconomic
policy into credit growth, the federal government will have to play a similar role.

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Conclusion: Credit policy at the Fed
Traditional monetary policy works through a single, economy-wide variablea single
interest rate or perhaps the money supply or growth of credit. Credit policy, by contrast,
aims at directing credit in specific forms towards specific groups of borrowers. In the
words of Borio and Disyatat (2010), credit policy consists of central bank operations
targeting specific segments of the private debt and securities market. This policy can be
implemented in a number of ways, including through modifications of collateral, maturity
and counterparty terms on monetary operations, by providing loans or acquiring private
sector claims, including equities Credit policy derives much of its effectiveness from
interposing the central bank (and hence indirectly the government) between private sector
lenders and borrowers (Borio and Disyatat 2010).

Traditional monetary policy works through a single,

economy-wide variablea single interest rate
or perhaps the money supply or growth of credit.
Credit policy, by contrast, aims at directing credit in
specific forms towards specific groups of borrowers.

Credit policy has historically been widely usedfrom Asian central banks directing lending
to strategic export and capital-goods industries; to efforts by the Bank of England and others
to assist in postwar reconstruction after World War II; to the longstanding U.S. policy of
supporting owner-occupied housing (Epstein 2013). Indeed, the creation of the Fed was
arguably motivated by a desire to channel credit to certain industries, specifically to support
U.S. banks in their effort to compete with British banks in provision of trade finance (Broz
1997). In recent years, the idea of credit policy has gone out of fashion in the U.S. and most
other countries, replaced by the idea that the central bank can set borrowing terms for the
economy as a whole without considering the credit demand or supply facing particular
sectors. But todays circumstances call for a return to a more active credit policyindeed,
the pendulum is already swinging back under the pressure of recent events.

Fed officials may be uncomfortable redefining their macroeconomic role in terms of credit
policy. They are more comfortable thinking of themselves as simply setting one overall interest
rate. But it is clear that the existing approach does not yield either macroeconomic stability
or reliable financing for productive investment. It is time that the Fed owns its role as an
immense island of central planning in the middle of the market economy (DeLong 2008).

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Central bankers like to think of themselves as mere custodians of the financial system, but
the social function of finance is to allocate societys scarce resources among investment
projects. Finance is responsible for redirecting economic activitya role that is especially
critical at times when major changes in the direction of activity are necessary. Due to the
looming threat of climate change, this is such a time. The terms and availability of finance
will be a central factor in determining how (or if ) carbon-based energy sources are phased
out; vulnerable coastal communities are protected or relocated; existing structures are
refitted to reduce energy use; land use patterns are reshaped to reduce reliance on the
automobile; and the scarce resources of water and arable land are developed, allocated, and
safeguarded. All of these choices require large, upfront expenditures to generate even larger,
but distant and uncertain, returns: in short, what banks are for.

These questions, and other similar choices about our collective productive activities, will
determine whether our grandchildren continue enjoying rising living standards and social
stability, or whether they face a new age of conflict and scarcity. As the ultimate arbiter of
credit and finance, the Fed has a central role to play here. Like it or not, the central bank is
a central planner, shaping both the character and the level of economic activity. It should
embrace this roleand the democratic accountability that goes with itand exercise its
power toward the public good.

Like it or not, the central bank is a central planner,

shaping both the character and the level of economic
activity. It should embrace this roleand the
democratic accountability that goes with it
and exercise its power toward the public good.

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