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The Fed Fixes Bayonets

Interest rates are close to zero as the Fed promises more unconventional measures.
Economist Staff, The Economist
December 17, 2008

Central bankers ordinarily strive to be boring. But these are not ordinary times. On Tuesday December 16th the Federal Reserve abandoned any pretence of business as usual and promised an all-out assault on the recession and the credit crunch.

After a two-day meeting the Fed’s policy panel, the Federal Open Market Committee (FOMC), announced three big measures: it has cut its target for the federal-funds rate to between zero and 0.25 percent, the lowest on record; it said that a weak economy would probably keep it there "for some time"; and having exhausted its conventional monetary ammunition, it promised a range of unconventional strategies, primarily purchases of mortgage-related securities and possibly Treasuries to push down long-term borrowing costs. Having run out of interest-rate bullets, the Fed has now fixed bayonets.

Alone, any of these steps would be momentous. Taken together they represent a formidable display of monetary aggression. That said, there is less than first meets the eye. Although the cut in the target for the federal-funds rate was larger than expected, it will have no measurable impact on the actual funds rate, which is charged on excess reserves lent overnight between banks. It had already fallen to around 0.1 percent, in anticipation of a target cut and because the banking system is awash with almost $800 billion of reserves. (The FOMC's move to a range rather than point target for the funds rate reflects the difficulty it has had hitting that target.) The Fed had announced on November 25th that it would buy up to $100 billion of debt directly issued by Fannie Mae and Freddie Mac, the now-nationalised mortgage agencies, and $500 billion of their mortgage-backed securities (MBS). And in a speech on December 1st Ben Bernanke, the Fed chairman, had said that Treasury purchases were under consideration.

The Fed did not go much beyond any of that in its statement. However more important than specifics, and of greatest significance to the stockmarket, which soared on the announcement, was the assurance of radicalism. "The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability," it said in its statement.

Economist Fed

Whether it will be enough remains the biggest question. The Fed has succeeded in bringing previous recessions to an end by cutting short-term interest rates. But now having cut the funds rate as low as it can realistically go, that is in doubt. Its new, unconventional operations have been dubbed "quantitative easing" because their effect is felt through the Fed's control over the quantity rather than the cost of credit. Through the creation and expansion of an array of lending programmes, the Fed's balance has grown from below $900 billion to more than $2 trillion. Such programmes have kept the interest rates charged to private borrowers lower than they otherwise would be, but the effect has been difficult to detect, and certainly smaller than what the Treasury achieved through direct injections of public capital into banks.

In theory, purchases of longer-term securities could have more impact by pulling down longer-term interest rates. The ten-year Treasury yield, for example, is 2.36 percent, and the 30-year conventional mortgage-rate is around 5.5 percent. But whereas the Fed knows more or less just what it has to do to move short-term interest rates up or down, it is in uncharted territory on longer-term interest rates. Indeed, theory suggests that the purchases would have to be spectacularly large to affect such huge, globally integrated markets.

A senior Fed official rejected the notion that the Fed was trying explicitly to target lower long-term rates, and rather framed the Fed's new actions as an extension of previous efforts at restoring liquidity and normal trading conditions. The official said that yields on Fannie's and Freddie's MBS, despite the explicit support of the Treasury, are much higher than Treasury yields because of a lack of liquidity. The Fed can narrow that spread, he said, by providing investors with the confidence that a committed buyer is in the market.

Although the Fed may yet buy longer-term Treasuries, the benefits are less clear: yields are already low, there is no lack of liquidity and it is not clear that lowering them by another 10 basis points would bring mortgage rates down by an equal amount. Thus for now it makes sense for the Fed to focus on those rates that most directly affect the economy.

The economy certainly needs it. On the morning of the Fed announcement the government reported that housing starts in America had plunged by 19 percent in November, from October, to an annualised level of 625,000, the lowest level on record. The only positive interpretation is that reduced construction should bring down inventories of unsold homes, although builders are now battling for sales with a wave of foreclosed properties.

Inflation has retreated at a surprising and, possibly, alarming rate. The consumer-price index fell by 1.7 percent in November, from October, the largest fall on record, largely as a result of plunging petrol prices, dragging the overall inflation rate down to 1.1 percent from 5.6 percent in July. Excluding food and energy, "core" prices were unchanged and the core inflation rate has sunk to 2 percent, from 2.5 percent in July. Much of the drop in core inflation is a by-product of falling energy prices flowing through to air fares and other energy-intensive categories. But the trend is almost certainly lower as rising unemployment and slumping sales eat into wage and price power. The senior Fed official said that he does not think that outright deflation is a risk but the situation bore watching. The day after the Fed's decision the dollar weakened considerably.


There are some glimmers of economic hope. The drop in petrol prices has delivered a sizeable boost to household buying power, one reason why retail sales in November were not as weak as expected. Home sales have remained stable, helped by declines in mortgage rates. Shares have been range bound (though the range is wide) since mid-October. On Tuesday shares of Goldman Sachs rallied by 14.4 percent as it reported an expected $2.12 billion fourth-quarter loss. Interbank-loan rates have edged lower. A same Fed official said that there has been little change recently in the Fed's economic outlook: it expects continued contraction through the first quarter followed by a weak recovery.

One of the most encouraging signs, arguably, is that the Fed's balance sheet has stopped growing in the past month, an indication that it has, for now, sated corporate and financial borrowers' demands for short-term credit. Of the $150 billion of short-term loans that the Fed offered this week, banks bid for only $63 billion worth.

That pause is almost certainly temporary. In the coming months the Fed will inaugurate several big new lending programmes, including a facility for backing asset-backed securities and the purchases of MBS. Although the financial backdrop has, for now, stopped getting worse, the Fed is taking no chances.




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