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“I want to be clear at the outset that I am not saying that it is appropriate for fiscal policy makers to increase the long-run level of public debt,” Mr. Kocherlakota said. But it could help push up the level of so-called neutral rates in a way that would also allow the Fed’s interest-rate target, when set to neutral levels, to be higher than currently appears to be the case, he said.
Because the neutral interest-rate level for the Fed is lower than in the past, the central bank has less room to cut rates when trouble arises, Mr. Kocherlakota explained. He said the Fed can deal with its inability to lower rates into negative territory by way of buying long term assets, but he noted that there doesn’t seem to be much appetite any longer for providing stimulus this way.
The government can step into this situation by borrowing more debt and putting pressure on interest rates, moving them higher, the official said.
“This additional debt issuance would reduce the likelihood of the FOMC’s hitting the lower bound on the nominal interest rate. The FOMC would be better able to achieve its employment and price objectives,” Mr. Kocherlakota explained.
Keeping in mind that despite how he introduced his comments, what nearly every U.S. politician and government bureaucrat really heard was “the Fed wants us to borrow and spend more to help them fight off recessions!”, we should take a moment to explain how interest rates work to see what he’s after.
Interest rates represent the price of debt, and like all prices, they are subject to the laws of supply and demand, where the interest rate, or in the case of government-issued debt security, the yield, represents a balance between the two.
Here, the people who loan money to the government want to get the highest yield possible because the higher the yield, the more money they make. Meanwhile the government wants to have the yield set as low as possible, because that means the cost of its borrowing is less.
This is where supply and demand come into play. Here, when the government needs to borrow a certain amount of money, the yield for government-issued debt securities is adjusted until it succeeds in borrowing that amount of money. If the yield it offers is too low, too few lenders will offer to accept the deal, so the government will have to increase the yield it will pay to them over the term of the debt security.
But if there are many lenders who seek to loan money to the government, such as is often the case when the economy is struggling so much that investing elsewhere presents too much of a risk, the government can hold out on making a deal with them unless they lower the yield they will accept.
That’s significant for the economy as a whole, because most interest rates that regular Americans and businesses can get for the loans they take out are directly tied to the yields of government-issued debt securities. When the yields on U.S. Treasury bonds, bills and notes rise and fall, so do all those other interest rates.
As a general rule, when interest rates rise, making it more costly for regular Americans and businesses to borrow money to support productive activities, it tends to restrain economic growth, while falling interest rates tend to stimulate economic growth as debt becomes less costly. The Federal Reserve’s ability to affect interest rates is perhaps its most powerful tool for trying to affect the growth rate of the U.S. economy.
Now, let’s consider the current condition of the U.S. economy. At this point in 2015, it has been bad enough for long enough that interest rates have fallen to nearly zero. If a new shock were to negatively impact the economy under these circumstances, the Fed would not be able to us its power to stimulate the economy by loaning massive amounts of money to the U.S. government to force interest rates lower.
So when Minneapolis Fed president Kocherlakota says that having the government go on a debt-driven spending binge might be desirable, he’s doing so because he’s afraid that the Fed won’t be able to minimize the negative impact of the next recession.
Which according to an accidental leak of its confidential five-year economic forecast for the U.S. economy late last week, is an increasing near-term concern of the Fed’s staff economists.
But here’s the thing: To make that scheme work, the U.S. government doesn’t need to issue a gargantuan amount of new debt so large that it would turn off lenders from loaning any more money to the government unless it significantly raised the yields they would be paid.
The Fed could get there a lot more quickly by simply refusing to lend money to the U.S. government, which wouldn’t require the U.S. government to borrow any more than it currently plans today. Which if you think about it, is exactly what the Fed will be doing when it finally turns the screws to start hiking interest rates for the first time in eight years. And since the Fed has become the largest single holder of publicly held U.S. government-issued debt securities, it is the 800-pound gorilla in the U.S. Treasury auction room and could make it happen all on its own any time it wanted to.
That it hasn’t says quite a lot. In fact, the more we think about it, the less serious a realistic proposition it seems.