The Federal Reserve's Next Experiment - Pegging Long-Term Interest Rates

I recently posted an analysis of an two-part article written by Ben Bernanke on his Brookings Institute blog.  The first article looked at the Fed's current monetary policy arsenal, focussing on negative interest rates as a possible monetary tool.  Here is a look at part two of Mr. Bernanke's musings on the economy, looking at how the Federal Reserve can target or peg long-term interest rates to achieve its goals.   Long-term interest rates are key to economic performance since this is the part of the yield curve that is most likely to influence economic activity and, as such, influencing these rates directly could play a very important (not to mention risky) part of the Fed's policies.

Mr. Bernanke opens his posting by noting that it is highly unlikely that "exotic policy tools" including negative interest rates and targeting long-term interest rates will be used in the United States anytime soon.  In the past, the Fed has manipulated the interest rate curve by influencing very short-term interest rates, for example, the federal funds rate as shown on this graph:

In case you've either forgotten or were unaware, the Federal Reserve defines the federal funds rate as:

"...the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight. When a depository institution has surplus balances in its reserve account, it lends to other banks in need of larger balances. In simpler terms, a bank with excess cash, which is often referred to as liquidity, will lend to another bank that needs to quickly raise liquidity.  The rate that the borrowing institution pays to the lending institution is determined between the two banks; the weighted average rate for all of these types of negotiations is called the effective federal funds rate.  The effective federal funds rate is essentially determined by the market but is influenced by the Federal Reserve through open market operations to reach the federal funds rate target."

Here is a graph from FRED showing the fed funds rate in orange and the rates for one-, five-, ten- and thirty-year Treasuries:

Note how the up and down movements of the interest rates for the Treasuries more-or-less track each other, however, the ten- and thirty-year rates are far less influenced by the movements in the federal funds rate than the one- and five-year rates.  It is these rates that the Fed could target with its basically untried and untested long-term interest rate policies.

As an aside, there has been one notable historical exception to the Federal Reserve's short-term rate targeting.  In April 1942, after the United States entered the Second World War, the Federal Reserve committed itself to maintaining an interest rate of 3/8 of one percent on Treasury Bills and also imposed an upper limit on interest rates paid on long-term government debt of 2 1/2 percent.  At the time, there was a great deal of concern that there would be a return to the pre-war Great Depression-style economy with very high unemployment.  In addition, there was a great deal of concern about the debt being incurred to finance the war effort.

An October 2010 internal Federal Reserve memorandum looks at the strategy for targeting long-term interest rates that is available to the Fed when short-term interest rates are at the lower zero bound.  To implement this policy, the Federal Reserve would have to use outright purchases of Treasury securities to achieve its interest rate objectives, similar to the policy that it used during its quantitative easing program.  In both cases, large quantities of securities are purchased  however, in quantitative easing, the quantity of assets purchased are set in stone and prices of the securities vary and in long-term interest rate pegging, the price of the assets purchased are set in stone and the quantity purchased varies.  To give you an idea of how much impact large-scale asset purchases (i.e. QE) has on interest rates for long-term securities, Fed staff estimates that a $500 billion purchase would lower interest rates on longer term Treasuries and private debt securities (i.e. corporate) by only 15 to 20 points.  This would boost the level of real GDP by approximately one-half and three-quarters of a percent after two years. 

Here is an example of how the Fed could manipulate longer-term interest rates.  Let's assume that the fed funds rate is sitting at its current zero percent and that the two-year Treasury rate is sitting at two percent.  The Fed could announce that it wishes to push two-year rates down to one percent up to a certain completion date; it could enforce this interest rate ceiling by purchasing any Treasury security that matures up to two years in the future at a price that corresponds to a yield of one percent (keeping in mind that the price of a bond is inversely related to its yield).  This approach would only work if bond market participants believe that the Fed's actions will be successful at pushing down the two-year rate and that the Fed will not abandon the program before its completion date (i.e. if there was a sudden and unexpected increase in inflation).  If bond market participants felt that there was a chance that the Fed would abandon its program early, the market could be flooded with bond sellers and there is a possibility that the Fed would own most or all of the two-year bonds, making its ultimate influence on interest rates uncertain.

Mr. Bernanke goes on to note that it is far easier to target shorter-term interest rates than rates further out, an observation that you can make for yourself on the graph above which shows the current yield on a broad spectrum of Treasuries.  If the Fed were to target ten-year rates by offering to purchase securities at fixed prices for two years following the announcement, any changes in the economy that shifted the path of short-term interest rates over any part of the ten-year horizon could destabilize the peg and lead investors to sell massive volumes of Treasuries to the Fed, once again leaving the Fed "holding the bag".  As an example, just imagine what would happen if the economy were to experience another Great Recession-style economic slowdown during a Fed interest rate pegging program.  The impact on the Fed's balance sheet would be massive and could lead to a wide variety of unintended consequences.

One additional problem exists.  If, as noted above, the Fed was inclined to target rates beyond five years, as you can see on this graphic, there is far less inventory of marketable Treasuries greater than 10 years in length:

    

Near the end of 2015, the volume of maturities were as follows:

less than one year - $3.35 trillion

one to five years - $5.48 trillion

five to ten years - $2.59 trillion

ten to twenty years - $288 billion

twenty years plus - $1.41 trillion

Given that the Fed's balance sheet expanded from $869 billion in mid-2007 to its current level of $4.484 trillion and with this data in mind, it looks like the Fed may not have much of an option to impact interest rates down the yield curve beyond the five year mark because there simply won't be enough "bang for its buck".

In closing, the internal Fed memorandum notes that the long-term targeting policy would offer both risks and benefits:

"Benefits include the potential to reduce both the level and volatility of interest rates, and thereby to provide stimulus to economic activity and bring the yield curve closer to that which policymakers might regard as desirable given prevailing economic conditions. In addition, in conjunction with clear communication of the interest-rate targets, yields could decline due to signaling effects, tending to lower the magnitude of purchases required to keep interest rates near target. However, interest-rate targeting also entails some risks. If targets are not adjusted frequently enough to account for changing macroeconomic conditions, interest-rate targeting can induce substantial volatility in central bank securities holdings and have a destabilizing macroeconomic effect. The Federal Reserve was confronted with these problems following both World Wars as a consequence of its policy of pegging the prices of U.S. government securities."

While targeting longer-term interest rates could prove to be yet another experimental monetary policy that is of some use to the Federal Reserve when the economy slows down, like the other policies that the Fed has adapted since the Great Recession, its effectiveness at prodding the economy back to life is unquantifiable and the risks may outweigh the benefits.