Tuesday, December 16, 2008

Recognizing reality 

As Mark Perry noted this morning, the Fed Funds rate has been effectively zero for some time. This afternoon, this was made official.

The central bank on Tuesday said it had reduced the federal funds rate, the interest that banks charge each other, to a range of zero to 0.25 percent. That is down from the 1 percent target rate in effect since the last meeting in October. Many analysts had expected the Fed to make a smaller cut to 0.5 percent.

...The Fed's action and statement made clear that economic conditions have worsened since its last meeting in October.

Federal Reserve Chairman Ben Bernanke and his colleagues said they will use unconventional methods to try to contain a financial crisis that is the worst since the 1930s and a recession that is already the longest in a quarter-century. For example, the Fed last month said it planned to purchase up to $600 billion in direct debt and mortgage-backed securities issued by big financial players including Fannie Mae and Freddie Mac in an effort to boost the availability of mortgage loans.

Krugman says we're in the soup now. ZIRP soup, they'll call it, for Zero Interest Rate Policy. It is now obvious that the Fed's concern is deflation, not inflation. You see to your right a chart of commodity prices by one measure; the size of this decline is unprecedented certainly since WW2; I'd have to research some other records to see what happened before WW1, and it's finals week here so I don't have the time. Justin Fox observes that this is a change of attitude: All of the previous activities have swapped out T-bills for lower-grade securities. Now they appear prepared to just buy them outright, for new currency.

My colleague Rich MacDonald reminds me of when Ben Bernanke spoke about this in 2002:
Once the nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash. At this point, the nominal interest rate is said to have hit the "zero bound."

Deflation great enough to bring the nominal interest rate close to zero poses special problems for the economy and for policy. First, when the nominal interest rate has been reduced to zero, the real interest rate paid by borrowers equals the expected rate of deflation, however large that may be. To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.

Although deflation and the zero bound on nominal interest rates create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value. When William Jennings Bryan made his famous "cross of gold" speech in his 1896 presidential campaign, he was speaking on behalf of heavily mortgaged farmers whose debt burdens were growing ever larger in real terms, the result of a sustained deflation that followed America's post-Civil-War return to the gold standard.
Sudeep Reddy, reading that same speech, observes that Bernanke argued for the central bank to target a longer-term interest rate. The two-year bond currently yields 0.65% (one reason why the effective Fed funds rate had to go to zero -- shorter term maturities were about there already). The Fed could decide even to purchase foreign government debt, though it would have to be seen as not bailing out a foreign government (according to Bernanke's speech.) Whatever they do, James Picerno says, it's a gray area.

It's worth noting that Bernanke argued that a tax cut financed by monetized deficits would be "essentially equivalent to Milton Friedman's famous "helicopter drop" of money." He adds:
Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.
What do you want to bet someone in the Obama transition team has already cut out that quote for delivery to its new economic policymakers?

Labels: ,