As Darren Winters explains, the interest-rate peg approach could be used by the Fed to combat the next financial crisis.
In the 2008 financial crisis, the Fed set a target to buy a fixed amount of securities every month, known as quantitative easing QE.
Asset prices were propped up with QE with the aim of creating the wealth effect. But QE is also controversial because it creates uneven wealth distribution, with wealth being skewed to those who have access to the cheap money and laden with assets.
But based on a recent Fed study entitled, “How Does Monetary Policy Affect Your Community?”
QE as we know it could be replaced with the Fed’s interest-rate peg approach.
What is the difference between QE and the interest-rate peg approach?
Darren Winters talks through the fact that both policies require asset purchases but instead of the Fed targeting the number of assets purchased every month the Fed will adjust its asset purchases around setting or planning an “interest rate peg”. So for example, if the Fed wants to keep the One-year Treasury yield around 1% they enter the open market and make asset purchases to drive the price of one-year treasuries higher and their corresponding yields lower. Note that there is an inverse relationship between the treasury’s price and its corresponding yield. In other words, as the price of treasuries increase their corresponding yield falls.
So the Fed’s interest-rate peg approach aims to keep the government’s borrowing costs down. Moreover, when the Fed targets treasuries with short maturity dates this has the added benefit of not bloating the Fed’s balance sheet with excessive assets.
Fed’s interest-rate peg approach which specifically targets treasuries with short term maturity dates is in effect QE unwind.
Fed’s interest-rate peg approach could be a huge shift in how the next crisis will be handled
Short-term interest rates are already at zero, for the Fed, that is still the lower bound.
So when 0% short-term interest rates are no longer enough to stimulate the economy, the Fed might announce a target for slightly longer-dated interest rates, such as one-year rates, said Fed Governor Lael Brainard.
“It would buy just enough securities with those maturities, to bring the one-year yield down to the target range. And if more stimulus is needed, it might target two-year rates,” said Fed Governor Lael Brainard.
Fed’s interest-rate peg approach means that the central bank would be on standby to use its balance sheet to hit the target interest rate.
“Such an approach could help communicate publicly how long the Federal Reserve is planning to keep rates low,” added Lael Brainard.
So the Fed’s interest-rate policy is an “interest-rate peg”
But the Fed’s interest-rate peg approach is not new. The Fed already implemented a rate peg before to help provide cheap financing for the US war effort during World War II.