Six years ago Ben Bernanke made a speech that led to his nickname “Helicopter Ben” when he described how the Federal Reserve could increase the money supply by dropping dollars on the populace. The more serious part of the speech, however, deal with different ways the Federal Reserve might fight a recession by intervening in the credit markets.
- The Zero Interest Option. Bernanke proposed that the Fed could “commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time–if it were credible–would induce a decline in longer-term rates.”
- The Interest Rate Ceiling For Long Term Debt. Bernanke indicated that he preferred a more direct menthod of holding down long term interest rates: “the Fed [could] begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.”
So far the Federal Reserve seems to have followed the first method, which was also the policy favoured by Japan when it began its long and slow fight against deflation. Many market watchers now think the Federal Reserve is switching to focus on long term interest rates, and may in fact have already begun to target these directly. Some believe that Bernanke will make this policy explicit when he testifies to Congress in February.
But which targets and how? John Jansen, who blogs at Across The Curve, thinks the market may be misreading Bernanke’s plan. “The market, I think, believes that Bernanke will busy himself buying 10 year and 30 year paper,” Jansen writes. But he points out that Bernanke specifically mentions using caps on two year Treasuries to adjust interest rates. So wouldn’t the Fed be buying those?