Tony Lima
September 7, 2010

In a recent posting on the Economist‘s Free Exchange blog, Joe Gagnon offered his proposals for changes to current U.S. monetary policy.  While he has some good ideas, a few simply won’t work.  For those who haven’t yet read Mr. Gagnon’s piece, let me quote his bio (because I’m too lazy to rewrite it): “Mr Gagnon is a senior fellow at the Peterson Institute for International Economics. He was also the visiting associate director for the Division of Monetary Affairs at the Federal Reserve Board from 2008 to 2009. Previously he served at the Federal Reserve Board as associate director, Division of International Finance (1999–2008), and senior economist (1987–1990 and 1991–97).”

So, without further ado, here are Mr. Gagnon’s proposals.

1. Cut the interest rate on bank reserves from its current 0.25% to zero.  This is actually a pretty good idea.  Right now, banks can earn a full quarter percent on their deposits at the Fed.  After all, your bank probably won’t pay you much more than that on your savings account.  For example, Wells Fargo is offering a whopping 0.05% APY on its “Goal Savings” accounts in California.  (Caveats: this data is as of September 7, 2010.  And different rates may be available in other states.)  And, unless you’re willing to maintain a minimum balance of $2,500 or so, the interest rate on your checking account balance will most likely be zero.  So banks can borrow from you (which is how deposit accounts look to bankers) and lend to the Fed, earning a nifty spread of at least 0.20%.  Cutting the interest rate on reserves to zero would at least give bankers a small incentive to do something besides accept deposits and make money by “lending” to … the Fed!

2. The Fed should target the yield on 90-day Treasury bills at zero.  The Fed can create enough money to do this, without a doubt.  But who will purchase T-bills that pay zero interest?  Mr. Gagnon is banking on his forecast of deflation to create a positive real return on these instruments.  Betting on deflation over a three-month period is best left to folks who spend a lot of their time in Las Vegas, not central bankers.  Mr. Gagnon’s proposal would, essentially, mean that only the Fed and other central banks would purchase these securities.  I wonder if this is what he intended.

3. The Fed should bring down the interest rate on 4-year U.S. government Treasury notes to 0.25%.  According to Mr. Gagnon, the current rate on these notes is 1.0%.  The Fed could, of course, easily create enough money to purchase those notes in the quantity needed to bring the interest rate that low.  But there’s one question that remains: who else will purchase those notes at an interest rate of 0.25%.  While Mr. Gagnon forecasts deflation in the short run, inflation rates in the U.S. have mainly stayed positive.  And, of course, if the inflation rate is 1.5% over the next four years and the yield on those four year T-notes is 0.25%, the real interest rate will be -1.25%.  The Fed and other central banks can easily live with negative real rates of return.  It’s positively amazing what you can accomplish when you have the power to create money!  But will any private investors buy those notes?  Undoubtedly a few will, but private demand will shrink markedly.

Mr. Gagnon favors what amounts to quantitative easing.  Actually I’m in favor of his proposals.  But creating negative real rates of return for private investors is not the way to stimulate the economy.