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Can the Fed Target Italian Interest Rates?

Piazza Venezia, Rome, Italy
Panoramic Images | Getty Images
Piazza Venezia, Rome, Italy

If Europe's woes threaten to push the US economy into a recession, shouldn't US policy makers do something about it?

More specifically, if unsustainable Italian interest rates are rebounding to crush the US economy, shouldn't the Federal Reserve direct its monetary policy in ways that will lower those interest rates. Shouldn't the Fed announce a target rate for Italy?

Let's imagine how this would work. The Fed could announce that it will not allow rates on Italian sovereign debt to exceed a certain level.

It would buy Italian bonds with newly created dollars until the rates hit the target.

This would probably be a massive buying program. It would expand the money supply. But right now the world is demanding far more dollars, preferring obligations of the US government to almost any other asset in the world. There's no reason to suspect that this would be inflationary.

What's more, buying Italian bonds would not have the distorting economic effects that buying other financial assets might have.

There are two problems with this plan. First, it would be enormously unpopular politically. Republicans already want to impeach Ben Bernanke. Bailing out Italy would probably result in howls of outrage.

As one Wall Street wag put it to me, the Tea Party would burn down Olive Garden in reaction.

Second, it would be a stunning act of economic imperialism. The Fed would be usurping the role of the European Central Bank. The economic fate of Europe would suddenly be in the hands of US central bankers.

Ironically, the bailout would undermine the sovereignty of European governments.

So this almost certainly won't happen. But we certainly could do it if we wanted to.

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