After Rates Go to Zero, What Happens Next? Or, Why Does the Fed Seem to be Acting So Wacky?

First off, I’m no economist. I mean, I have studied it in school and recently in my studies as a CFA Level III candidate, but trying to write a bit about even just a small part of what is going on right now is tough and may prove to be mere folly.  There are so many variables to consider. So many moving targets, changing relationships and new correlations/relationships introduced between variables.  It really needs to be a full time job to study all this… stuff.  And it seems that economists get it wrong more times than not anyway, so why even bother?  I don’t know, but I like to write about it, so here it goes…

As you may know, on December 16, 2008, the Fed lowered the fed funds rate (generally defined as the interest at which private depository institutions lend balances at the Federal Reserve to other depository institutions, usually overnight.)  Typically, such low interest rates have been associated with periods of deflation (a drop in consumer prices).  Pundits are still undecided if we are in period of deflation or not.  Sure seems like it to me with the collapse of the energy and commodities bubble.  Maybe these are the same pundits that couldn’t make up their minds if we were in a recession or not until a few months ago. 

The Fed uses the fed funds rate to heat up the economy by lowering the rate to stimulate borrowing, spending, and to loosen credit markets.  But, once the rate goes to zero, obviously, this tool no longer applies… it has been used up so to speak.  So what happens then? What other measures are available to the Fed for further monetary stimulus?  Many have already been instituted by the Fed during most rare and damaging financial crisis.  Drastic times call for drastic measures I guess.

1) Pushing cash (bank “reserves”) directly into the banking system.

We certainly have seen plenty of this. Since rates were already so low, the Fed tried to bypass the system by injecting cash directly into the system.  $8o0 billion last November alone.  But if there is no desire to borrow or lend, the method will have limited effect.  Just go ask Japan.

2) Promise to hold short-term interest rates low for an extended period of time. This can have value normally if markets do not think that rates will soon raise due to an expected recovery.  I’m pretty sure that most market participants believe that the recovery is a ways off. People saying by the end of 2009 are kidding themselves. Keeping rates so low also forces banks to lend or suffer loses as yields on bonds they own become lower than their cost of funds.  A shout out to Mark Sunshine at Seeking Alpha for shedding some light on the other current reasons for keeping rates next to nothing. Check out his article “How the Fed Is Making Banks Lend”.

3) Buy assets directly from the private sector.

AIG, CITI, Freddie and Fannie, MBSs, TARP.  It’s been a toxic spending spree of historical proportions.  Most of this has been to add much needed liquidity to the credit markets.  And to drive down yields on these assets. Japan has been doing this for years.  1o year bond yields have been driven down below 1% at times.      

4) Devalue the currency.

Increase the money supply and the dollar gets devalued.  Maybe those undecided-on-deflation-or-not pundits have a point.  The dollar certainly has been falling as of late, after a nice rise, but also after a long decline.  So how much further can it/will it drop this time around?  Is this the last tool left for the Fed in the fight against the severe recession? Maybe, it is time to book that trip to Europe now rather than later.  For those of you who can still afford it that is.