Money financed fiscal stimulus – the most powerful policy at zero level bound

I mam trying to read the papers presented at this Boston Fed conference – Revisting Monetary Policy in Low Inflation Environment.

I was reading this Laurence Meyer paper where he looks at Fed policy in this crisis and their impact.

First how much did Fed’s purchases of assets (QE) impact US Treasury? He says a Fed program of USD 400 bn lowered 10 yera treasury by 13 bps. There are 3 more studies in the estimate of 13-14 bps. As all similar, he says they must be true!!

Impact of QE on economy:

We find that a 50-basis-point decline in the ten-year Treasury rate, as a result of $2 trillion additional Treasury purchases, would, of course, lower the unemployment rate and raise inflation over the intermediate term. In that sense, LSAPs work. But, in the scale we assume, LSAPs is not a game changer. We estimate that it would lower the unemployment rate by only ½ percentage point by the end of 2012 and only marginally raise the inflation rate. Of course, if the  effects are linear, we can always estimate, in principle, the size of asset purchases that would produce whatever macro effects the FOMC wants. But we also have to remember the limited tolerance of the FOMC to further expand its balance sheet. Today, the amount of Treasuries held outside the government is about $8½ trillion; presumably the Fed will be reluctant to hold too large a proportion of that debt on its balance sheet. A cumulative increase of $2 trillion to a balance sheet of $4 trillion may already exhaust, if not exceed, that tolerance.

On communications:

Communication matters. But pushing back market expectations by one year at this time has only a temporary peak affect of 35 basis points after about six quarters, and then fades to zero. The further out expectations are changed, the smaller the effect of pushing those expectations back by another year. Today, we would argue that the use of communi cation intended to shift back expectations about the timing of exit, especially alone, would be puzzling to the markets, even if effective as discussed above. The time for focusing on exit is over. Today, the question is whether,  when, and how the FOMC will ease. That is what we want to hear about. That is what the FOMC should communicate about. 

He then looks at two other tools under zero level bound. Targeting US 10 year bond and money-financed fiscal stimulus (basically Fed finances fiscal stimulus). Both he sees as powerful tools. Though with US 10 year already wvery low, impact is limited. But for second option, the gains could be huge:

The stimulus afforded by this policy combination will, of course, only be as powerful as the size of the fiscal stimulus.
But monetary accommodation will make sure that the macro effect of any fiscal stimulus is the largest possible. We simulate the effect of this by assuming a fiscal stimulus comprised of a payroll tax holiday for two years.

Here we do so under the assumption that the funds rate remains at the zero bound and that the FOMC engages in LSAPs to limit any increase in longer term rates. A two-year payroll holiday would directly lower taxes by about $1 trillion dollars in 2011 and 2012, a larger stimulus than in the first Obama package, and more frontloaded as well.

unemployment rate falls by two percentage points by 2012 and 2013, and the inflation rate increases by more than half of a percentage point by 2013. There would of course be a pay-back effect at the end of the two years, again presenting a challenge to sustain above-trend growth when the stimulus abruptly ends. But hopefully, by this time, credit markets will have substantially healed and de-leveraging may be completed.

Nice analysis. Bottom Line:

The FOMC appears ready to implement its first option, LSAPs, for providing additional monetary stimulus to lower the unemployment rate and increase inflation towards its dual mandate. It is important, therefore, to look at estimates of the  effect of LSAPs using different methodologies. If they give us very similar results, as we found here with the Hamilton-Wu paper and research at Macroeconomic Advisers and in Gagnon et al, we will have more confidence in the results.

LSAPs, while the first easing option, may not be the last. We therefore explore the effectiveness of other options, specifically FOMC communication, targeting the ten-year yield, and money-financed fiscal stimulus. The latter two could be very  powerful, though with much higher threshold for action than LSAPs. But, given the uncertainty about the outlook, and the very significant downside risks starting from such a high unemployment rate and low inflation rate, we sum up the threshold for the latter two options as: Never say never!

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