timesonline.co.uk
March 17, 2003
Economic Agenda By Lea Paterson
Fed zeroes in on interest rate plan B
DOES the Fed have a plan B? With policymakers at America’s central bank mulling another cut in interest rates this week, there are only a few rolls remaining of the traditional monetary policy dice. In today’s geopolitical environment, it is easy to see circumstances where the Fed would soon need to lower rates from their current 1.25 per cent level to as low as 0.5 per cent. That would leave the US only a small step away from what would have been unthinkable a few years ago — zero interest rates.
Japan illustrates only too clearly the perils that zero interest rates can bring. Once rates are zero, policymakers are unable to kickstart the economy by traditional means, that is, by reducing short-term borrowing costs directly. Instead central bankers have to think laterally, and be ready and willing to adopt unorthodox plans of attack.
In Japan, policymakers were years too late in moving towards less conventional measures. All the signs are that Fed officials have learnt from the Japanese experience, and will do all that is possible to avoid the same mistakes. The Fed not only has a plan B, but will move aggressively to put it in place once rates in the US fall to zero. If the American economy continues to stumble, plan B could be in action later this year.
Fed officials have long been considering what could, and what should, be done if US rates drop to zero. A Fed research paper published last year* provided an extensive review of Japan’s experience with deflation, and set out a long list of policy errors that America ought to avoid. Chief among the report’s recommendations, and the Fed’s philosophy for the past two years, was the need to take out “insurance” against deflation by cutting rates sharply in response to global economic weakness. With this in mind, the Fed has sanctioned a dozen interest rate cuts since January 2001, although these have not yet been enough to assure a US economic recovery.
By the time Japan was approaching zero interest rates, inertia among policymakers had ensured that deflation was already entrenched. The same is not true of America, where aggressive policy action has meant that, if the US approaches the zero interest rate bound, it will be with a positive inflation rate. The implication is that the challenge facing the Fed at zero interest rates will be significantly easier than that which faced the Bank of Japan (BoJ). But the road ahead for America remains a difficult one.
Recent comments by Fed officials suggest the criticism of inertia will not be one levied at US policymakers. Indeed, it seems the very first stage of plan B — that is, a PR offensive — has already been launched. Fed officials, Alan Greenspan included, have recently dismissed suggestions that policymakers become impotent when rates fall to zero. According to Ben Bernanke, a Fed Governor, speaking late last year: “Some observers have concluded that when the policy rate falls to zero, monetary policy loses its ability to further stimulate the economy. This conclusion is clearly mistaken.”
The PR offensive aside, what does plan B consist of? Most economists are agreed that, when rates fall to zero, the initial response ought to be some combination of two options. First, policymakers can commit to keep rates at zero for a specified period of time. This commitment, if credible, can influence longer-term borrowing costs. Second, policymakers can seek to influence longer-term interest rates directly by buying up government bonds.
Remarks by Fed officials seem to suggest that the central bank has rejected the first of these options, but is enthusiastically behind the second. According to Mr Bernanke, his personal preference would be for the Fed to announce an explicit target for medium-term interest rates — for example, the yield on two-year Treasuries. This would then be enforced by Fed purchases in the US Treasury market that would push bond prices higher and bond yields down.
Significantly, Mr Greenspan devoted a sizeable chunk of a recent policy speech to the topic of bond purchases. The Fed Chairman pointed out to his audience that between 1942 and 1951, government bond purchases allowed the the Fed to cap the yield on long-term US Treasuries at 2.5 per cent. Mr Greenspan is famed for pouring over every nuance of his speeches, and his discussion of bond purchases was no accident. As a result of hints such as this, most Wall Street analysts expect government bond purchases to be the Fed’s first line of attack if and when rates fall to zero.
Government bond purchases could be put in place even before US rates hit zero. One of the themes of the Fed speeches and papers on deflation is that pre-emptive action is key. The suggestion from Fed officials has been that contingency arrangements ought to be in place before rates hit zero, and not announced after the zero-bound has been reached. With that in mind, a move by the Fed to begin to purchase government bonds later this year is not beyond the realms of possibility — especially given that the central bank does need to seek additional authority to operate in the Treasury market.
What if plan B fails? The Fed is already lining up a plan C, a plan D and even a plan E if the worst happens. One suggestion floated by Fed officials has been that the central bank would initially begin buying short-term US debt, and then expand this to longer-term bonds if the economy fails to respond. Were this to come to nought, then there are range of other possible options. These include offering banks zero-interest loans with commercial assets such as corporate bonds issued as collateral.
In extremis, the central bank could also buy foreign government debt — a move which would almost certainly lead to a sharp decline in the dollar. If the US economy slips into a Japanese-style deflation, it certainly won’t be for a lack of effort on the Fed’s part.
* Preventing deflation: Lessons from Japan’s experience in the 1990s. Available at federalreserve.gov
lea.paterson@thetimes.co.uk |
