No major institution in the US has so poor a record of performance over so long a period as the Federal Reserve, yet so high a public reputation.

– Milton Friedman (1988)

The default risk on the US government bonds may be small, but the interest rate risk is huge. The 10-year US Treasury bond yield touched 4.87 per cent in early October 2023, up from a low of about 0.5 per cent in 2020. Relatedly, some 10-year “safe” US government bonds slumped by 46 per cent!

It is interesting that much of the interest rate risk is not due to the market; it is due to the public authorities. The focus here is on the Fed. After 2021, the Fed started raising interest rates to deal with high inflation. This was finally a clear reversal of the earlier policy in the aftermath of the Great Recession around the year 2007, when the Fed started reducing interest rates. The Fed has varied the interest rates massively over time. Is an alternative policy possible? Yes.

To begin with, note that during a recession, the demand for funds shifts downwards, and during a boom, recovery, or inflation, it increases compared to normal times. So, relative to normal levels, interest rates in a hypothetical and benchmark free market would have been somewhat low in a recession, and high in a boom or strong recovery. Now, let us discuss a policy correction, presented here in a simplified version.

First, consider the actual and familiar policy. To restore the demand for funds after 2007, the Fed adopted the policy of what may be called very low administered interest rates. This policy entailed excess demand for funds, and so the Fed issued more money. And, recently the Fed is maintaining interest rates at very high levels, where the demand for funds is low relative to the prevailing supply. So, the Fed is absorbing the excess money. The concern here is that the interest rates have been varied considerably over time.

Next, consider the proposed policy. Surprising as it may sound, the Treasury can intervene instead of the Fed to set interest rates right. The Treasury can act in this matter on the advice of an independent advisory body.

In a recession, the Treasury can restore the demand for funds by giving a subsidy to reduce the effective interest cost incurred in making real investments only (Warren Buffett cannot borrow at subsidised rates to invest in stocks). This policy shifts the demand for funds upwards, and so the interest rates observed in the market move up towards the normal levels from the low free-market levels. This happens while the effective (net of subsidy) interest rates for borrowing for giving a push to spending in the economy can be reduced to substantially low levels.

In an unhealthy boom or inflationary times, the proposed policy is to do the opposite. A tax can shift the demand for funds downwards, and so the interest rates observed in the market move down towards the normal levels from the high free-market levels. This happens even as the effective (inclusive of tax) interest rates for borrowing for real investment are increased to substantially high levels.

We see that under the proposed policy, the interest rates observed in the market are not far away from the normal levels over an economic cycle; it is only the effective rates for borrowers for real investment that vary considerably. In contrast, under the actual Fed policy, there is only one set of interest rates. These are varied considerably over an economic cycle, and the path of the rates can be uncertain, long-drawn, and messy. It follows that the interest rate risk is very high under the actual policy but not under the proposed policy. The very high interest rate risk at present is man-made; it can be reduced substantially by a fresh policy.

As seen earlier, the actual policy in a recession is blunt; it allows low-cost borrowing for all purposes. In contrast, the proposed policy is well-targeted, offering low-cost borrowing for real investment only. It may be argued that the proposed subsidy in a recession may be misused. This is not easy, at least not in the US. Even if there is some so-called misuse under the proposed policy, this is no different from what is considered normal use under the actual policy. So, the proposed policy is superior, even if there is some so-called misuse.

To conclude, the actual Fed policy may work well for macroeconomic stability but it has a big adverse side-effect for “safe” US government bonds and other assets. In contrast, the proposed Treasury policy can work well for macroeconomic stability and asset price stability.

The writer is an independent economist. He has taught at Ashoka University, ISI, and JNU. gurbachan.arti@gmail.com