The Fed Reaches the Floor

Ground Zero for US Interest Rates

The official judges on whether the United States is or is not in a downturn (the NBER) are now saying that the USA entered a technical recession at the end of last year. It takes some time for the statistics to provide concrete proof of this – a nation’s GDP data is always three to six months behind the times.

What is clear is that the world’s biggest economy is in serious trouble as the financial crisis spreads to Main Street and millions of jobs are at serious risk. To state that that millions of jobs might go is not an under-statement. Half a million jobs were lost in November alone.

Yesterday the United States Federal Reserve pulled on the monetary policy interest rate lever one last time. It announced a reduction in the federal funds rate to a new level of ‘between zero and 0.25 per cent’ – which means in practice that the interest rate at which the Federal Reserve is prepared to lend to other financial institutions is now at the floor.

Managing confidence and demand

The main aim of lowering interest rates is simple – to drive down the cost of borrowing for consumers and businesses in an attempt to stimulate confidence and demand in the domestic economy thereby helping to stabilise output and jobs during what promises to be a deep and painful recession.

Some students wonder why – if official interest rates are zero – why it is that loans, overdrafts, credit card rates and numerous other interest costs for borrowed money remain positive – often way above the so-called ‘policy rate’.

The main answer is that most loans – be it for a mortgage or an investment project for a company – are for much longer periods of time than the overnight lending or surplus funds between the banks within the inter-bank market.

So a property-buyer or business looking for loan finance will pay a rate of interest equal to the ‘risk free’ interest on government securities (bonds) of similar duration plus a risk premium that the lender requires as an insurance against the loan going bad. In short - the greater the risk of a borrower defaulting on their loan, the higher is the rate of interest charged.

The credit crunch has made lenders more cautious about lending – risk premium spreads have risen in most financial markets. As a result, deep cuts in policy interest rates by most of the world’s central banks have done little to reduce the real cost of credit for personal and business customers. This is one reason why monetary policy can become ineffective as a tool for managing aggregate demand.

Let us head back to the decision of the Federal Reserve to cut official interest rates to zero. Does this mean that there is nowhere else for monetary policy to go to prevent a deflationary depression?

Turning on the taps

Not quite, some of you may have read about the possibility of the US Central Bank taking some highly unusual steps which boils down to effectively printing money to stimulate liquidity in the financial system. This is known as quantitative easing and the easiest way of describing it is to say that the central bank would buy directly different types of existing debt – say long term government bonds or the dodgy debt of the failed mortgage giants Freddie Mac and Fanny Mae – and print money to pay for their purchases. This injection of money into the economic system would boost the money supply and keep interest rates low.

The Federal Reserve could – in principle – buy any outstanding assets held by the private sector of the economy – and print money to pay for them. They could guarantee to buy up fresh government debt issued by the government – for example extra government borrowing to fund President-elect Obama’s fiscal policy recovery programme.

Added to this, Ben Bernanke at the Fed could announce that the central bank expects to keep short term interest rates at super-low levels for the foreseeable future – a strategy designed to embed into people’s minds that the nominal cost of borrowed money ought to remain minimal. One of the problems of the liquidity trap is that – when interest rates are driven to zero – our expectations are that the next move will be upwards and that this could happen swiftly. The Fed needs to avoid this expectation.

Martin Wolf discusses many of these issues in his excellent piece in the Financial Times – available here. He flags up one idea – that the central bank could simply send everyone a cheque with some money to spend – perhaps using some time limited coupons?

So in the weeks and months ahead, keep a look out for some of the key decisions of the US Federal Reserve. As students you are living through an amazing moment in nearly a hundred years of economic history.

And what will the Bank of England do in response to events both here in the UK and also overseas? Is it prepared to go the distance and reduce the BoE policy rate to zero? We will find out in early January or February.

Here are three follow up articles on the latest cut in US interest rates:

BBC news: US rates slashed to nearly zero

Guardian (Chris Payne): The Fed has waved a white flag

Independent: US slashes interest rates to new zero-0.25% range

Telegraph: UK needs negative interest rates, L&G warns

The Times (Gerard Baker): Fed throws out the rulebook