Matt Yglesias has a good piece on Slate about the Fed and inflation. He asks if the Fed is really powerless to create inflation and mentions a point I have been saying since QE2 was implemented:
“The Fed could, on that view, simply buy all the outstanding debt in the country and then tear it all up. Wouldn’t that be a bonanza? “
So how could this work? First, the reason why QE has been failing to a large degree is because monetary policy is about setting prices. When the Fed sets the Fed Funds Rate target they name a price and essentially challenge the market to compete with them over that price. The Fed could do the exact same thing at the long end of the curve. They could come out and challenge the market to try to move the 30 year bond above 1% for instance. The banks would lose because the Fed has an unlimited pile of reserves at their disposal. This is how the Fed conducts monetary policy. They are a bully and all the other children know they’re a bully. A very mean bully who you just don’t mess with.
Slamming the 30 year bond down to something close to zero would pancake the entire yield curve to the point where borrowing for long durations didn’t just become affordable – it would become a no-brainer for many businesses, households, etc. And with housing being the crux of this balance sheet recession and the most important part of the consumer balance sheet I think it would make a substantial impact on the economy. Yes, I really think that that extra 2-2.5% in current yields would make a difference. But like Yglesias, I am not necessarily saying this is what the Fed should do. But the mechanics behind it aren’t terribly complex….