Commentary: Joseph Gagnon’s monetary policy proposals

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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.

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About Tony Lima

Retired after teaching economics at California State Univ., East Bay (Hayward, CA). Ph.D., economics, Stanford. Also taught MBA finance at the California University of Management and Technology. Occasionally take on a consulting project if it's interesting. Other interests include wine and technology.

3 Replies to “Commentary: Joseph Gagnon’s monetary policy proposals”

  1. rami nasri

    Professor Lima what you wrote was interesting. Yet, if you don’t mind me asking, I have few questions.
    The first proposal Mr. Gagnon presented made sense but regarding the 90-days t-bills, how can you expect deflation in such a short period of time and make people purchase those bills ??? Also, since the inflation rate is about 1.5% and it will stay like this in the near future, this means that in order for investors to consider the 2nd and 3rd proposals, the deflation rate should be at least around 1.5%-2.0% sorry for asking a lot of questions but I really want to understand how the fed would use its instruments to stimulate the economy and I really learn a lot from reading your postings .

  2. Tony Lima

    Rami, those are exactly my points. I don’t expect deflation over the next 90 days or four years. But deflation is the only way to create a positive real rate of return on those securities. And without a positive real rate of return, the only buyers will be central banks.

    Let’s consider an example. Suppose a one-year T-bill has a yield to maturity of exactly zero. We know that real rate of return will be the nominal rate minus the inflation rate. If inflation is +1% the real return will be 0% – (+1%) = -1%.

    Now suppose there is deflation. Say the inflation rate is -1.5%. The real return will be 0% – (-1.5%) = +1.5%.

    In other words, without deflation Mr. Gagnon’s proposals will cause private buyers to avoid Treasury securities because the real rate of return is, at best, zero (if inflation is zero). The only remaining buyers are the Fed and other central banks. (When you have the power to create money you really, really don’t care about rates of return on stuff you buy!)

    The success of Mr. Gagnon’s proposals hinges on actual deflation happening in the real economy. And deflation would pretty much have to occur over a one-year horizon. Actually, with a nominal yield of 0.25% on four year securities, the real return will most likely be negative without deflation since inflation rates between 0 and 0.24% are within the error ranges of estimates of the CPI and GDP deflator.

    I hope this clarifies things a bit. – Tony

  3. rami nasri

    Thanks professor Lima it did clarify things for me. Its just hard sometime to relate what I have learned at school with what some economist propose because most of the time, what they say does not make sense and it counter all what I have learned about economics. Thanks again for your inputs