NEW YORK, Nov 21 (Reuters) - It’s a dilemma most central banks would rather avoid but the Federal Reserve is being forced to confront: the risky business of pushing interest rates all the way to zero.
The dreaded zero mark lends a scary, skittish quality to the conduct of monetary policy. Ordinarily, policy-makers rely on lowering rates to promote growth. Yet with borrowing costs at a bare-bones 1 percent, a half-point cut would amount to half the U.S. central bank’s ammunition.
That is not to say the Fed will run out of tools to influence the economy if it decides it needs to press rates to zero, and if the latest news of declining prices turns into a more pronounced deflationary trend.
Possible further steps include a commitment to keeping rates low for a prolonged period of time, or a broader expansion of the assets the central bank accepts as collateral for loans. [ID:N21468337]
But the Fed would be operating in largely uncharted territory, with much more uncertainty than stability-seeking central bankers are generally comfortable with.
“Some of these alternative policy tools are relatively unfamiliar,” said Russell Jones, global head of fixed-income research at RBC Capital Markets. “They may raise practical problems of implementation and calibration of their likely economic effects.”
The Fed appears well aware of these pitfalls. Minutes from its last meeting in October pointed to a policy-setting committee made less concerned with inflation by a worsening economy, but one that also felt some nervousness regarding the potential need to bring official rates down to zero.
“If resource utilization remained weak for some time, inflation could fall below levels consistent with the Federal Reserve’s dual mandate for promoting price stability and maximum employment,” the minutes said, an allusion to the possibility of mounting deflation risks.
Such a development “would pose important policy challenges in light of the already-low level of the committee’s federal funds rate target,” the Fed said.
Still, the central bank signaled it was willing to cut rates further to stop what has become an accelerating raft of bad news, including steep job cuts and a grim outlook for lending, and financial markets expect a half-point cut when the central bank meets in mid-December.
One worry is that money market funds, which already came under pressure when the Fed’s abundant liquidity measures pushed the effective fed funds rate to zero in the markets, could see shares once again break below $1.
“I’m of the view that if they cut, it’s going to be another 50 basis points and then they’ll stop,” said Anna Piretti, economist at BNP Paribas. “Otherwise everybody would just start pulling out of money market funds and that would create a lot of systemic issues.”
Others, however, believe the Fed would not sacrifice the wider economy to spare money markets, and note the central bank and U.S. Treasury have already taken steps to support the sector.
“We do not think this cost is enough to constrain the Fed, in part because facilities such as the Money Market Investor Funding Facility should help to provide a more orderly transition for this market,” said Michael Feroli, an economist at JPMorgan.
Indeed, the Fed has good reason to act aggressively if it sees a deflation threat. When prices fall, inflation-adjusted rates rise even if nominal borrowing costs are held steady -- and that can further undercut growth and worsen the deflation.
THE ROAD TO TOKYO
The challenge of conducting policy with interest rates pegged at the “zero bound” has been keeping Fed Chairman Ben Bernanke up at night since he served as a member of the central bank’s Board of Governors earlier in the decade.
Back in 2002-2003, he was a big proponent of keeping rates low for a considerable period to prevent a Japanese-style period of deflation. Bernanke saw this as a way to pull down long-term interest rates by influencing the market’s view on the path short-term rates would follow.
With prices already pulling back in an economy where activity seems to have ground to a halt, a deflation battle could be brewing again. U.S. consumer prices fell by 1 percent in October, the biggest drop on record and one that should continue given the sharp reversal in energy and commodities.
What policy-makers would like at all cost to avoid is a pervasive and self-reinforcing decline in costs and price expectations that would likely prolong the recession the economy already appears to have fallen into.
Japan has been battling deflation on and off since the late-1980s, and the U.S. central bank would likely turn to some of the same solutions eventually adopted by the Bank of Japan.
In fact, Fed Vice Chairman Donald Kohn acknowledged for the first time on Wednesday that the U.S. central bank was effectively already engaging in “quantitative easing,” the purchase of assets and taking on of collateral aimed at lowering yields and therefore the cost of capital financing.
The Fed could turbocharge existing measures in order to prevent a deflationary spiral. To its benefit, it has recognized the threat much earlier than the BOJ.
This gives policy-makers room to act preemptively, either through an explicit commitment to keeping rates at unusually low levels for some time or through broader purchases of assets, to include both riskier securities and safer, longer-dated ones, such as 10-year Treasury notes.
“The Fed could target long-term interest rates,” noted Tony Crescenzi, chief bond market strategist at Miller Tabak. “In his now famous November 2002 speech on deflation, Bernanke said that the Fed could try to stimulate spending by lowering interest rates further out the yield curve.”
“The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to the maturity date to which it is targeting,” said Crescenzi.
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