Kohn, Donald

Unorthodox monetary policy may work, but it obviously would have to be through channels other than reducing short-term interest rates since they are already at zero. Those channels might include reducing expected short-term rates by tilting down long-term rates, or reducing term or risk premiums in long-term rates. The latter also would tend to reduce long-term rates and exchange rates as well.

Pumping up the monetary base by itself would be unlikely to be effective in doing either of these things, that is, reducing short-term rate expectations or term and risk premiums. Such increases in the base would tend to go into excess reserves and there is no obvious reason why that would change expectations about future rates. Tilting open market operations to a limited degree toward bonds or foreign exchange also is not likely to do much. Studies show that modest changes in the supply of bonds, Operation Twist kinds of things, do not have much effect on bond yields. Sterilized intervention, which is what in effect such foreign exchange buying would be, also does not do much. However, massive purchases of bonds or massive intervention might. The Federal Reserve did set the rate on government bonds during World War II. If a central bank were willing to purchase all the supply of government bonds, it could set the bond rate again, and presumably this would feed through to corporate borrowing rates as well. So, there are extreme policies involving massive purchases that should work in lowering term premiums and risk premiums.

Presented as part of the staff briefing at the June 30-July 1 FOMC meeting in 1998.