The Last Bullet

US policymakers are running out of options to solve our massive unemployment problem and get the economy growing again. The Administration’s jobs bill faces resistance in Congress. The best option that can be implemented without a vote of Congress is to work through the market that started this mess in the first place—housing. The Administration has made a good start by announcing that it plans to make it easier for underwater mortgagors to refinance and repair their balance sheets, but some of the details to be filled in will be important in determining the ultimate effectiveness of the program. In addition, to boost the overall economy and to maximize the benefits of mortgage refinance, the Federal Reserve should announce new large-scale purchases of agency guaranteed mortgage backed securities (MBS) with the goal of keeping the 30-year mortgage rate between 3 and 3.5 percent through the end of 2012. These purchases would have beneficial spillovers into almost all other financial markets.

The Cartridge Is Almost Empty

The Fed’s decision in September to sell short-term Treasuries and buy long-term Treasuries (known as Operation Twist) has put downward pressure on long-term interest rates. But, with the 10-year yield already down to about 2 percent, the scope for further reductions is somewhat limited. One percent is probably the effective lower bound on the 10-year Treasury yield.

The Fed currently pays banks interest at 0.25 percent on reserves held at the Fed. This rate can and should be lowered to 0.0, but such a move is small beer as the interest payments total only $4 billion per year.

Financial market participants currently expect that the Fed will keep short-term rates near zero for at least the next two years, consistent with the Fed’s announcement in August. The short-term interest rate implied in the Treasury yield curve for one to two years ahead is 0.4 percent and that for two to three years ahead is only 0.8 percent. There is little scope to push these rates lower. Any announcement about future Fed policy more than three years ahead is not likely to have any effect on financial markets because no monetary policy commitment can be credible that far ahead. In particular, it is generally agreed that sound monetary policy should aim to return the economy to trend within three years and no one believes that the interest rate will remain near zero after we have returned to full employment.

Some have proposed that the Fed announce a desired path for the future price level (or future nominal GDP) that is higher than that currently expected by the markets. It is argued that such an announcement would raise inflation expectations, lower real interest rates, and stimulate economic activity. However, it is not clear that such an announcement, by itself, would have much effect. Indeed, during the past two years, there has been little tendency for market forecasts to move toward Fed forecasts. To increase its effectiveness, any such announcement should be accompanied by concrete actions to push market conditions in a supportive direction. The best option available is a massive program of MBS purchases.

Why Housing?

There are several reasons for the Fed to focus on the market for housing finance:

  1. The market for agency MBS is one of the largest markets in which the Fed is allowed to operate. The Fed is not allowed to buy equity, real estate, or corporate debt.
  2. MBS yields are the most important factor behind mortgage rates. As investors have flocked to the perceived safety and liquidity of Treasuries, the spread between mortgage rates and yields on 10-year Treasury notes has risen considerably. Fed purchases are especially effective at reducing those interest rates whose spreads to Treasuries are wider than normal.
  3. Lower mortgage rates help to repair the balance sheets of households hurt by the collapse of the housing bubble, both by lowering the cost of debt service through refinance and by supporting purchases of houses and thus the price of housing.

To have maximum effect, the Fed should indicate a target range for mortgage rates and commit to maintaining rates in this range through December 2012. Given the weakness of the economy, there is no significant chance that the Fed would wish to reverse its easy policy stance before the end of 2012. By making such a commitment, the Fed would encourage mortgage originators to create extra capacity to handle a large volume of activity. A relatively long commitment would provide assurance to those who are considering whether to begin shopping for a new home.

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