WSJ -- Fed's Next Interest-Rate Cut May Be Smaller Than Expected.
June 20, 2003
Fed's Next Interest-Rate Cut May Be Smaller Than Expected
With Rates Nearing Zero, Fed Faces A Quandary: How Low Can They Go?
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
WASHINGTON -- With the Federal Reserve apparently ready to cut interest rates next week, officials indicated Thursday that a quarter-point cut remains firmly on the table, despite the market expectation of a half-point cut.
Fed officials emphasized they haven't decided how far to move rates next week and are keeping all their options open. But beyond that next rate cut, the Fed now faces a daunting challenge: How to continue to ward off potential deflation when short-term interest rates are closer to zero than they have been in 45 years.
Several months ago, officials said that in such a near-zero scenario the Fed could keep rates down by buying Treasury bonds, as it did in the 1940s. Such a buying spree would raise bond prices and lower their interest yields, which move in the opposite direction. But after months of study, Fed officials have concluded that today's far-more-complex bond market would frustrate that strategy.
The Fed's key rate already is at 1.25%. After next week's move, cutting it even closer to zero will pose problems. Too low a rate would imperil money-market mutual funds, for instance, because they might no longer clear enough money to cover expenses and pay a return to investors. It would leave the impression the Fed was out of rate-cutting ammunition. And a zero rate could disrupt the market in which Treasury bills, commercial paper and bank deposits trade. Why would a bank borrow in the money market when the Fed is providing ample funds free of charge?
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So Fed officials are concluding the best alternative tool for boosting growth is persuading investors -- through careful communication -- about its intentions on short-term rates. It must convince investors that rates will remain low long enough to extinguish fears of deflation and ensure that economic expansion is well entrenched. Deflation is dangerous because falling prices often lead to falling wages, making it hard for companies and households to pay back debts. While the Fed can raise interest rates as high as it wants to fight inflation, it can't cut them below zero to fight deflation.
The Fed already has had surprising, if unexpected, success in sending such messages to investors. After their May 6 meeting, Fed officials declared lower inflation to be a bigger risk than higher inflation. From that, investors concluded the Fed would keep rates low much longer than had been thought, and drove bond yields down. Long-term rates -- 10 or more years -- are more than half a percentage point lower than they were before the Fed statement, even after rising in the last few days. The low rates gave mortgage refinancing and the rest of the economy a boost even though the Fed hadn't touched its short-term federal-funds rate, which is charged on overnight loans between banks.
Financial markets Thursday were betting that the Fed will cut the Federal funds rate by half a percentage point this coming Wednesday. But Fed officials are uncomfortable with that expectation because the Fed hasn't decided the size of any rate cut and doesn't want to shock the markets.
Fed Chairman Alan Greenspan recently said that while the risk of deflation is small, it was a dangerous-enough outcome that it was worth taking out insurance to keep the risk small. To back up his rhetoric and keep bond yields at their new lower levels, Mr. Greenspan will likely recommend a rate cut next week, the first cut since November.
Most colleagues, some of whom wanted to reduce rates months ago, are apt to agree. The bigger question is by how much.
The case for a quarter-point cut rests, in part, on tentative signs of a pickup in the U.S. economy, including reports to the Fed from business contacts that order books are starting to fill. That's a contrast to comments Mr. Greenspan made just two weeks ago that there was still no evidence of a postwar acceleration in the U.S. economy.
The inflation picture isn't as worrisome as Fed officials thought a month ago. Officials have been alarmed that inflation excluding food and energy, which had fluctuated between 2% to 3% since 1995, has slowed sharply to a 1.3% annual rate since September. That is near the minimum many officials say is needed to maintain a buffer against deflation. But prices of items other than energy jumped 0.3% in May. Fed staff also suspect statistical quirks in figuring home-ownership costs may have exaggerated the apparent slowing of inflation. These factors argue for a smaller interest-rate move.
Still, Fed officials say they don't want to assume the data are wrong, especially when the stakes are so high. If inflation is really headed below 1%, the Fed needs to act aggressively. That, along with still-weak job markets and capital spending, argues for a half-point move.
But the most difficult question facing Fed officials is what to do if one more cut doesn't restart the economy. Back in November, Mr. Greenspan told Congress that if short-term interest rates ever hit zero, the Fed could repeat its 1940s strategy of buying bonds to force down long-term interest rates. Trying to reassure lawmakers that the scenario was unlikely, he added, "This is an academic exercise."
It doesn't seem so academic now.
At next week's meeting, Fed policy makers will likely review results of an intense research effort into ways to boost the economy when the federal-funds rate is close to zero. It is headed by Vincent Reinhart, chief of the division of monetary affairs and secretary to the Federal Open Market Committee, with input from Dino Kos, who runs open-market operations at the Federal Reserve Bank of New York.
The more the Fed has studied targeting bond yields, the more difficult it has looked. Fed governor Ben Bernanke, a Princeton University academic, last November spelled out how the Fed bought large quantities of long-term Treasury bonds to enforce a 2.5% ceiling on yields between 1942 and 1951. Targeting bond yields "would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios," Mr. Bernanke asserted.
But bond trading is far bigger and more complicated than it was in the 1940s. Buying bonds might be a useful signal to the markets, much like intervention in foreign-exchange markets. But it might fail if the markets viewed the world differently than the Fed. Furthermore, the Treasury market is now inextricably linked to other markets, such as for interest-rate derivatives, mortgage-backed securities and foreign exchange. Nobody knows how an artificial target yield enforced by the Fed would ripple through those markets.
Then there's the question of what Fed officials call the "exit strategy." The Fed got rid of the wartime 2.5% ceiling in 1951 only after a fierce battle with the Treasury, for which the ceiling held down borrowing costs. All these problems mean that while the Fed may still buy bonds, it is not likely as a stand-alone strategy.
The most effective way to convince investors that short-term rates will be low for a long time is to lower them even further. But as rates fall to zero that presents additional problems, such as the viability of money-market mutual funds. In the last two weeks, the Fed's supervisory staff, who monitor the safety and soundness of banks, have been visiting money-market funds to ask how they'd be affected by a federal-funds rate as low as 0.25%, a manager at one bank-owned fund said.
A zero funds rate also might cause the money market itself -- where everything from Treasury bills to eurodollars and federal funds are traded -- to stop functioning normally. As rates drop to zero, the incentive for banks or other institutions to put idle cash to work by buying short-term IOUs diminishes. Markets lose their ability to differentiate between riskless Treasury bills and risky deposits. The Swiss central bank recently declared it can't reduce its target rate below the current 0.25%. Indeed, it found that actual rates have been slow to match the target because banks need to cover transaction costs.
Fed officials are inclined to see some of these as regrettable but acceptable costs of bolstering the overall economy. After all, the pain is borne by a "clearly identifiable and narrow" segment of Wall Street, such as money-market fund managers, Mr. Reinhart said recently. "A more serious concern" with zero rates, he said, is the potential harm to confidence: "Low rates risk fostering the misimpression that monetary policy is ineffective."
If the public believed the Fed was impotent, it might behave in way that would make the economy weaker and deflation more likely. All this suggests while the Fed would willingly slice the funds rate below 0.75%, it would resist going all the way to zero.
The Fed holds out its greatest hope for refined verbal strategies for guiding down long-term rates. They have studied so-called precommitment strategies, under which the Fed would promise to hold the funds rate low for a set period of time, or until a target is achieved -- such as a 2% inflation rate or 4% economic growth.
But other officials remain skeptical of precommitment strategies. Suppose Fed officials promised to keep rates low for two years: Would investors trust them to keep the commitment in the face of resurgent inflation and growth?
Still, Fed officials do broadly agree that no unconventional monetary policy is effective unless it convincingly shapes investors expectations about the future path of interest rates. They are reveling in their success in doing exactly that on May 6. The challenge now is to cement that success and learn how to repeat it if necessary.
Write to Greg Ip at greg.ip@wsj.com
Updated June 20, 2003
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