Waldman, provocative as ever, resuscitates a 2002 speech
by Ben Bernanke, wherein the future Fed chairman notes that the central bank
has more tools at its disposal than simply raising or lowering the Fed funds
rate. Specifically, he says, when liquidity premiums start to spike, as is happening
right now, the Fed can "offer fixed-term loans to banks at low or zero
interest, with a wide range of private assets (including, among others, corporate
bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral."
Steve takes this argument to its logical conclusion. Why does the Fed’s discount
rate always have to be higher than the Fed funds rate? "Suppose the Fed
were to offer to lend against specific sorts of collateral at a negative spread
to Federal Funds," he writes, and suppose that collateral were the nasty
products presently stinking up the banking system – RMBS, CDOs, that kind
of thing. To all intents and purposes, the Fed would be offering to buy those
assets from the beleaguered banks, which would help address the credit crunch
and the financial-sector problems which have driven the Fed’s last two rate
cuts. And if those problems were addressed, then the Fed could actually raise
the Fed funds rate in order to help contain inflation.
The Fed would have its cake and eat it too. It would promote full employment
by stopping a dangerous financial crisis in its tracks. It would promote price
stability by hiking interest rates to support the purchasing power (and FX
value, and commodity value) of the dollar.
There would be some danger that, even with the banks bailed out, interest
rate hikes would slow the economy. But that hazard is unusually small now,
because the binding constraint on lending is not the Fed-set interest rate,
but concerns about creditworthiness and quality of collateral… a bad situation
would be made very little worse by a moderate rate hike, if the financial
sector could withstand it.
Steve does note that there are very good moral-hazard reasons not
to do this. But once a house is burning, it’s a bit late for lectures about
not smoking in bed: the important thing is to put out the fire. In terms of
monetary policy, one way of doing that would be to bring the discount rate down
for certain types of collateral, even as the Fed funds rate could be raised
upwards. As a result, the unwise banks would be rewarded, while the better-run
banks would be punished. But the financial system and the economy more generally
might still benefit.