There is much debate over whether the Federal Reserve should tighten or further ease monetary policy. This dichotomous framing overlooks another possibility, which is whether the Fed should change the mix of its stance, tightening in some areas and further easing in others.

In particular, there are strong grounds for the Fed to abandon its support of the Treasury bond market and to raise gradually the federal funds rate (to say one per cent), while simultaneously increasing its purchases of mortgage backed securities. If permissible, the Fed should also purchase state government bonds according to a per capita formula.

Such a recalibration of policy could have positive effects. Increased purchases of MBS will help the housing market, which remains at the heart of the US economy’s problems. Declining house prices continue to inflict financial losses on banks and consumers, and the prospect of further price declines deters buyers and undermines new construction. Increased MBS purchases could help stem this problem by further lowering mortgage rates. That would help households by facilitating more mortgage refinancing, help banks by reducing foreclosures and help the construction industry by making home ownership cheaper.

This measure would be most effective if paired with the relaxation of Federal Housing Administration, Fannie Mae and Freddie Mac standards for refinancing of mortgages. Refinancing still viable mortgages that have low or even negative equity would provide a big boost to the distressed corner of the household sector.

Purchases of state government bonds would lower financing costs for states at a time of large state budget deficits. That could help avoid cutbacks to state and local government employment.

Such purchases stand to help the corporate sector since MBS and state bonds are relatively close portfolio substitutes with corporate bonds. Lower MBS and state bond interest rates are therefore likely to spill over and lower corporate bond interest rates, which should help business investment spending.
Abandoning support of the Treasury bond market would cause some small increase in government bond rates. However, any private sector impact would probably be contained by the effect of expanded MBS purchases. Moreover, government interest payments are an income transfer to the private sector, a form of tax rebate. Consequently, increased interest income on government bonds would stimulate consumption spending, especially among households (such as retirees) that rely on such income.

The same logic holds for raising the federal funds rate. This would raise money market and deposit account interest rates, thereby helping savers. To the extent that such financial assets are disproportionately held by lower income households and retirees who spend most of their income, this would boost their income and consumption spending.

Raising interest rates in this fashion would also diminish tendencies towards speculation and excessive risk taking. Prolonged very low interest rate environments encourage yield chasing that over-inflates asset prices, and this process often ends in tears.

By chasing yield, households stand to suffer large losses should policy succeed in guiding the economy out of recession, thereby triggering higher interest rates. This risks a vicious double blow to households whose savings and pensions have already suffered from the financial crisis. Moreover, poorer, less financially sophisticated households are likely to suffer most from rising interest rates as the searing effects of the crisis have tilted money flows toward safe investments such as Treasury bonds. Banks are also at risk to the extent they have been parking excess reserves in longer bonds to exploit the slope of the term structure of interest rates.

One operational issue is how to make a higher federal funds rate stick given banks’ excess reserve holdings. The solution is for the Fed to accept interest bearing deposits from money market funds that serve retail investors. Under current policy, the Fed is committed to pay interest on reserves to banks. A better policy is for the Fed to pay interest to households by taking deposits from money market funds.

Throughout the financial crisis Fed and Treasury policy have disproportionately benefited banks and corporations. Banks were bailed out by the Troubled Asset Relief Program, benefited from regulatory forbearance such as suspension of mark-to-market rules and have profited from the Fed pushing short term interest rates to near zero which has widened the interest spread they earn. However, the policy has largely failed to directly help households and has instead relied on hopes of trickle-down effects from banks.

The failure to directly help households has been a grievous policy error. Along with banks and corporations, households have needed debt relief but this has not been forthcoming. Banks have resisted meaningful loan modifications, while many households have been unable to refinance mortgages at lower interest rates because of zero or negative home equity. Consequently, the household sector has remained distressed, which has deepened the recession.

It is high time monetary policy started working directly for households. The proposed recalibration of monetary policy would begin that shift and would help the economy escape recession. It would also reduce the likelihood of future disruptive repercussions from easy money now, and that too is good for households.

(Published in FT Economists’ Forum.com, August 27, 2010)