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--Fed Likely Forced To Use QE In Next Downturn, Former Economist Says
--Fed Officials Looking At Adjusting Framework For Times Of Low Rates
--Interviewee Joseph Gagnon Was Instrumental In QE1
By Pedro Nicolaci da Costa
     WASHINGTON(MNI) - The Federal Reserve will likely have to return to buying
large quantities of bonds once the next recession hits and is actively
considering ways it can adjust its policy framework to cope with downturns at
times when interest rates are already very low, according to Joseph Gagnon, a
former Fed board economist.
     Fed officials are wondering in particular whether the central bank's 2%
inflation target is set appropriately given how consistently the central bank
undershot it during the recovery from the Great Recession, Gagnon, who was
instrumental in devising the central bank's first round of asset buying during
the financial crisis and is now an economist at the Peterson Institute for
International Economics, told MNI.
     The concern that policy makers will again be confronted by the need to
further ease policy even as rates near zero is widely shared within the Federal
Reserve system, with many Wall Street economists predicting a possible downturn
by 2020. It is based on the simple assessment that average past recessions have
seen total interest rate cuts of 5 full percentage points.
     "I'm sure they'll be using QE," Gagnon told MNI in an interview at his
Washington office. "I think they should and that they should to it in a way that
is most consistent with the way they do conventional policy. You just move
smoothly down to there and then when you get there you just switch over to QE."
     Gagnon estimated that $300 billion in purchases of long-term government
bonds are equivalent to a reduction of around a quarter percentage point in
conventional interest rates.
     Future QE efforts could become embedded into a policy framework shift,
aimed in part at addressing the issue of the "zero-lower bound" in rates, he
     "There are many people [at the Fed] that are worried about this," said
     After leaving rates at zero for seven years, Fed has been raising them
gradually since December 2015 to a range of 2% to 2.25%. But now, the Fed is
increasingly seen as likely to pause rate hikes, and potentially ceasing them,
at around 3%, as early as next spring, as MNI reported last week. That means
additional tools may be needed to fight slowing economic activity.
     In response to the Great Recession of 2007-2009, the Fed not only slashed
official borrowing costs down to zero but ended up buying some $3.5 trillion in
U.S. Treasury and agency-backed mortgage bonds in an effort to keep long-term
rates down and spur economic recovery.
     One of the possible new approaches for the Fed would be to sometimes
overshoot the central bank's inflation goal to make up for past shortfalls, as
proposed by former Chair Janet Yellen, who recently argued that the central bank
should pre-commit to generating future booms following deep slumps as a way to
avoid the zero lower bound, Gagnon said.
     "By keeping interest rates unusually low after the zero lower bound no
longer binds, the lower-for-longer approach promises, in effect, to allow the
economy to boom," Yellen said at the Brookings Institution in Washington. The
Fed "needs to make a credible statement endorsing such an approach, ideally
before the next downturn."
     Her predecessor, Ben Bernanke, has offered his own plan for a temporary
price-level target that similarly commits the central bank to some kind of
economic overshooting during deep downturns.
     Whatever the eventual resolution, it's clear the debate is active. And
according to Gagnon and others, QE is part of the plan.
--MNI London Bureau; +44 203 865 3829; email:
[TOPICS: MMUFE$,M$U$$$,MT$$$$,MX$$$$]

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