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FRONT PAGE CONTRIBUTOR

Interest Rates Are Zero. What Does the Federal Reserve Do Now?

The Federal Reserve’s tool of choice for setting and communicating its broad monetary policy has been the level of the “Fed Funds rate.” You’ve heard many times that the Fed raises or lowers interest rates to cool down or heat up the economy.

“Fed funds” is the nickname for the reserve balances that banks are required to hold on account with the Fed itself. Banks can and do lend this money to each other on an overnight basis, and the “Fed funds rate” is the interest rate at which they do this.

Accordingly, the Fed funds rate is the most basic component of the cost of providing credit to the economy. It’s like the price of iron ore to a steelmaker. If you can manipulate the cost of credit, you can indirectly affect the rate at which the economy grows, because (in normal times anyway) people make business investments with borrowed money.

The Fed funds rate is set by a free market, but the Fed manipulates the rate by actively participating in that market each morning.

That’s the short explanation of what’s going on when news reports tell you that “the Fed lowered interest rates by half a percentage point today!” or whatever. A lower cost of credit theoretically makes borrowing cheaper, and it also decreases the relative attractiveness of holding money in the form of bank deposits rather than higher-yielding investments. That’s supposed to give economic growth a boost.

In a post-Keynesian world, it’s also the government’s most important tool for macroeconomic management. When we have recessions, the Fed typically counteracts them by reducing the Fed funds rate.

Why am I telling you all this? For one thing, the Fed’s Open Market Committee (which sets the Fed funds rate) is having their regularly-scheduled meeting in Washington. They’ll be announcing their policy statement around 2:15pm ET, as usual.

For another thing, it’s not all that clear what they can say today.

And that’s because interest rates are already effectively zero now. If you want to stimulate the economy, how can you reduce the cost of credit, if you can’t reduce its price?

First, let me explain the zero interest rate. The Fed funds target rate is currently one percent, not zero. However, if you look at the actual rate on any given night, you’ll find that it’s ranged between about 10 and 35 basis points over much of the last six weeks or so. There are technical reasons for this, relating to some operational changes the Fed made in October (they pay interest on Fed funds now, and they charge a 75 basis-point insurance premium on certain interbank transactions).

Bottom line, the effective Fed funds rate is already zero. Even if they announced a policy rate cut today, it wouldn’t change reality very much.

That means they need to do something completely different if they want to reduce the cost of credit. And this takes us into a very interesting discussion.

Before I tell you some of the things that the Fed might do, let me talk about this zero interest rate a bit more.

(I’m going to leave for another day the negative interest rates that you’re currently seeing on certain short-term Treasury securities and in overnight-repo. Ordinarily a cause for great concern, these negative rates are happening now at least partly because of normal year-end factors that will dissipate next month.)

Every recession is a little different. But in the post-war US, most of them have had internal dynamics that made them responsive to cheaper credit, provided either through market conditions or by government policy.

This recession is different in at least one distinctive way. It’s very rare to see so much reduction in consumer demand.

Think of it this way: you can make money really cheap and easy to borrow, but if no one wants to borrow any, then no one will borrow any. Leading a horse to water, and all that.

Now it’s true that we’re still in a totally-frozen market for private credit. Very few businesses could borrow money to finance expansion and hiring even if they wanted to.

And critically, that is NOT because the banks don’t have money to lend. On the contrary, the banks are loaded to the eyeballs with extra money. That has been the effect of all the Fed’s interest-rate reductions over the last fifteen months.

So why is it? I don’t know, exactly. It could be because banks don’t want to lend (and I could give you five good reasons why they wouldn’t). And it could be because businesses don’t want to borrow (because they’re afraid consumers won’t buy what they produce). Or it could be some combination of both.

This is one of the problems the Fed faces. The Fed funds rate is the basic cost of money to a bank. Add in all the risk-management and credit-intermediation that they do to the basic raw material (the Fed’s money), and you get money that’s applicable to the real economy.

But if you reduce the cost of the raw material and the banks still don’t produce credit, something else is going on. The Fed is attacking the wrong problem.

Or are they? What if there’s a difference between nominal interest rates and real ones?

If we are indeed experiencing the secular asset deflation that I’ve told you is inevitable to a certain extent, then a zero nominal interest rate might correspond to a real interest rate that is hundreds of basis points higher.

If indeed deflation is coming (or already here), then you could argue that a zero interest rate is actually felt by the economy as a very high rate. It’s as if the economy were overheating instead of going into deep recession, and the Fed were raising rates instead of lowering them.

All of these factors are probably playing into this situation to one degree or another.

But the Fed has to work not only with the tools it has, but also the intellectual framework it has.

Ben Bernanke and his team of economists have shown by words and deeds that they’re looking at the macroeconomic situation in classical terms, as a paucity of available credit in the economy. (Bernanke also uses the term “liquidity” in this connection. To me, as a Wall Streeter, that term means something different, but forget about that.)

Therefore, the policy response is to keep adding credit to the economy until things get better. When interest rates hit zero, you start flying helicopters and do things like go out into the market to purchase Treasury securities, which directly increases the amount of cash in the system.

They’ll even probably continue the shocking and extraordinary activities of last month, in which they purchased assets secured by mortgages and credit-card receivables. This is extraordinary because in so doing, the Fed is literally and directly assuming the function of private banks. They’re doing credit intermediation and taking economic risk.

What we have no way of knowing at present is whether today’s situation is a classical one, or something new. Markets, assuming the former, will certainly react positively if the Fed steps up its panoply of money-creating and credit-creating activity.

But will they make the economy get better?

Well, ask the question this way: Let’s say you normally buy a new car every two years, but you decided that this year you’d save some money and keep driving your old one for another year.

Is there any policy action the Fed could announce today, that would make you change your mind and buy the car? Probably not.

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