How Much Can The Fed Help Now?

Paul Krugman Conscience of a Liberal July 9, 2010

OK, there are signs that the Fed is nerving itself up to do something more to support the economy. The question is, how much are the kinds of actions likely to be on the table likely to matter?

Normally, the Fed’s power comes from its ability to move short-term interest rates. Now short rates on government debt are basically zero. Long rates, and rates on private debt, aren’t. But can the Fed do anything to change them?

Start with long rates on government debt. The simplest model of long-term rates is that they reflect expected short-term rates — that is, the interest rate on a 10-year bond is equal to the rate of return investors believe they would get if they put the same amount of money into 3-month Treasuries and kept rolling it over for the next 10 years. If that model were precisely correct, Fed purchases of long-term debt would have no effect at all on long-term rates — those rates would continue to reflect expected short rates, end of story.

In reality, things are presumably not quite that simple: buying a long-term bond exposes you to some risk of losing money if rates rise, so there’s presumably imperfect substitution between short and long. So the Fed can move long rates by buying long-term bonds — basically, it’s reducing the supply of these bonds to the public by buying them up, which would lead to a higher price/lower interest rate.

But how strong would this effect be? Even if the Fed bought a couple of trillion dollars’ worth, probably not all that large. I’m not saying don’t do it, but don’t expect miracles.

If the Fed is willing to buy private debt, this offers another margin for impact: since private debt carries risks, this makes it an imperfect substitute for public debt, and the Fed can once again reduce the supply to the public and drive up the price. Again, however, it’s not clear how strong the effect would be.

Way back when, Goldman Sachs guesstimated that it would take an expansion of the Fed’s balance sheet to $10 trillion to accomplish as much as the reduction in short rates the Fed would have undertaken already if it weren’t up against the zero lower bound. That still sounds plausible. Is the Fed ready to act on that scale? Probably not.

What would really be effective would be a credible commitment to a higher inflation target, which would reduce real interest rates. But that’s not on the menu, at least not yet.

So, it’s good to see the Fed getting worried; but don’t get too excited.

Paul Krugman is an Op-Ed columnist for The New York Times.

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How Much Can The Fed Help Now?

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