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Strategies & Market Trends : John Pitera's Market Laboratory -- Ignore unavailable to you. Want to Upgrade?

To: John Pitera who wrote (6029)	4/28/2002 1:22:46 AM
From: Jon Koplik	Read Replies (3) \| Respond to of 33421

NYT -- Fed Ponders What to Do If It Runs Out of Bullets. April 28, 2002 ECONOMIC VIEW Fed Ponders What to Do If It Runs Out of Bullets By RICHARD W. STEVENSON WASHINGTON -- After spending 2001 confronting the first recession in a decade and the economic aftershocks of Sept. 11, Alan Greenspan and his colleagues at the Federal Reserve took some time a few months ago to ponder the possibility of another crisis. What options would be open to the Fed, they asked themselves at their meeting in January, if the economy suffered another blow at a time when the official interest rates controlled by the central bank were already approaching zero? It was not an entirely academic question. Japan has been dealing with just such a situation for several years, with prices falling, the economy stalled and rates just a notch above nothing. The Fed itself has pushed official rates in the United States to their lowest level in four decades, with no assurance that the nascent recovery will continue — and with any number of threats hanging over the outlook, including a spike in oil prices and the risk of further terrorist attacks. If the worst happened, officials fear, the Fed would quickly run out of monetary policy ammunition, because it cannot push interest rates below zero, a self-evident limit known to economists as the "zero nominal bound." Should the economy become so weak that it experiences deflation — a general decline in prices — even holding interest rates steady amounts to tighter monetary policy. To understand why, consider how economists look at interest rates during normal times. Right now, the Fed's benchmark federal funds target rate on overnight loans among banks is 1.75 percent. That is what economists call the nominal rate. The inflation rate, depending on what measure is used, is somewhere in the same vicinity. Subtracting the inflation rate from the nominal rate yields the "real" interest rate, a better measure of the effect on the economy than the nominal rate. In this example, the real rate is around zero. But what if prices are falling? In that case, inflation is, arithmetically speaking, negative. So if the nominal rate was 1 percent and the deflation rate was 1 percent, the real interest rate would be 2 percent. In such a case, the economy could become prone to a deflationary spiral, in which a lack of demand, falling prices and paralysis in nominal interest rates lead to more restrictive financial conditions, weaker demand and further downward pressure on prices. Senior Fed officials began looking in earnest at this dire, if remote, possibility at a conference in Woodstock, Vt., in October 1999. They decided to take it up again last fall, after Sept. 11, and they devoted much of the first day of their two-day meeting in late January to the topic. They did not come to any firm conclusions on how to deal with such a situation. But they generally agreed that the best approach was to do everything possible to avoid letting the economy slip into a deflationary funk, even if that meant cutting rates more aggressively than usual as they approached zero. In other words, the consensus was that the Fed would do better to shoot off whatever limited ammunition it had left if faced with an economic flameout, rather than to conserve its remaining rate cuts in case things became even worse later. That thinking even played a role in the Fed's decision in November to cut rates by half a percentage point rather than just a quarter of a point. But what if aggressive easing does not work, and the economy is dead in the water with zero nominal interest rates? Could the Fed do anything to conduct monetary policy without cutting rates? The minutes of the January meeting refer only to a discussion of "unconventional policy measures" whose "efficacy was uncertain." Those no doubt included trying to inject money into the financial system by buying long-term government or corporate bonds or even stocks and real estate — steps that would be technically complex and politically explosive. The good news is that such a crisis seems less likely now than it did a few months ago. The economy rebounded smartly in the first quarter, growing at a 5.8 percent annual rate, the government reported on Friday, and the Fed has continued to pump money into the economy, fueling concern among some analysts that the threat later this year will be of overheating. There are even glimmers of hope from Japan, meanwhile, that it is at last pulling out of its slump, suggesting that a brush with the zero bound does not have to be terminal. Copyright 2002 The New York Times Company