Fed tosses out its rulebook

The Federal Reserve yesterday threw away the monetary policy rule book
it has been using for 50 years in its most dramatic effort yet to stem
the global economic crisis.

In a single stroke, the US central bank in effect eliminated the cost
of borrowing money between banks overnight. It promised that US rates
would stay at or near zero for the foreseeable future. And,
acknowledging that it now has no more room to cut rates, it announced
new, unprecedented measures to stimulate the economy, namely pouring
cash into almost every crevice of the financial system and massively
expanding its own balance sheet.

The two-day meeting of the Fed's open market committee which ended
yesterday must have been one of the most extraordinary in the central
bank's 95-year history. For more than a year the Fed has been
deploying all kinds of weapons – traditional monetary policy
implements as well as hastily-manufactured new ones – to prevent the
US economy from collapsing into a deep and enduring depression.

But, indicating the gravity of the crisis and the failure of all those
previous efforts to turn things around, Ben Bernanke, the Fed
chairman, and his colleagues, today threw every remaining tool in
their toolbox at the financial markets.

First, it cut rates once again from the existing one per cent to
something close to nothing. But, instead of announcing a target rate
for the overnight interest rate – as it has done for the last decade –
the Fed said it would aim to keep the rate in a range – between zero
and a quarter percentage point. This unusual move reflects the fact
that the federal funds rate – a market interest rate that the Fed can
move only indirectly – has been volatile recently because of
continuing strains in the interbank lending market.

Second, in its statement accompanying the move, it noted that the US
economy had deteriorated on almost all fronts in the last few weeks,
and it said that those "weak economic conditions are likely to warrant
exceptionally low levels of the federal funds rate for some time."

The Fed rarely commits itself to future policy decisions but those
words are tantamount to saying that rates will remain at or near zero
for a long time.

Third, Mr Bernanke has launched the US on an uncharted path of what
economists call "quantitative easing", emergency measures to stimulate
an economy in the clutches of deflationary collapse.

With short-term interest rates now at zero, the central bank can no
longer cut rates to stimulate the economy. Instead, it can in effect
print money, by buying up all kinds of assets and flooding the economy
with cash. The Fed's statement said it would begin buying
mortgage-backed securities on the open market. It also announced it
was evaluating buying up long-term government debt.

The significance of this development is that it will push interest
rates on these assets substantially lower from their already low
level. That should help stimulate demand.

The key difference in yesterday's announcement from everything the Fed
has done in the last year is that it is now going to buy up hundreds
of billions of dollars of these financial instruments, not simply lend
money to banks secured on some of those same assets.

There are risks to the central bank's action. Even lower interest
rates on both short-term and long-term lending may still not generate
much economic activity. What's more, printing money in this way – the
Fed's balance sheet will expand significantly as it acquires all these
assets from the markets – could risk an inflationary surge when the
immediate crisis is past.

But Mr Bernanke and his colleagues are surely right to think that is a
risk worth taking given the severity of the current crisis. Inflation
right now looks like a distant dream, as prices are plummeting.

That was underlined by news that consumer price inflation in the US
fell at its fastest rate on record last month. Prices fell by 1.7 per
cent in November, in large part as a result of declines in oil and
commodity prices, but prices were lower almost across the board.

The year-on-year rate of inflation fell to 1.1 per cent, from 2.7 per
cent a month earlier. The figures suggested the downward pressure on
prices is intensifying, raising the real risk of generalised
deflation, the ultimate nightmare scenario for policymakers.

As recently as July the annual rate of inflation was 5.6 per cent and
economists fretted about the risk of so-called stagflation – a period
of simultaneously rising prices and falling economic activity. Those
days seem long ago now, and it is clear that the greatest threat the
developed world faces is collapsing economic activity that pushes
prices down.

History suggests that once deflation takes hold it can be horribly
difficult to reverse. Consumers defer purchases and businesses put off
investment in expectation of lower future prices. The real value of
debt increases as prices fall. Since interest rates cannot go below
zero, the deflationary spiral means monetary policy, even at the
lowest feasible nominal interest rate, is still squeezing demand in
the economy.

Mr Bernanke's move seems to have been strongly influenced by what
happened in Japan in the late 1990s. Japan experienced deflation, when
prices began falling in 1998 but it took the Bank of Japan far too
long to begin a policy of quantitative easing similar to the one the
Fed now seems to be embarking upon. The Bank did not move until 2001
and It was only in 2005 that prices stopped falling.

A clumsy term that describes a complicated but crucial process. A
central bank does not directly set interest rates, but influences them
through the amount of cash it injects every day into the markets,
buying and selling assets such as government debt. The bank usually
buys or sells just enough assets to ensure the amount of cash in the
market keeps the interest rate at its desired level.

But with quantitative easing, the central bank buys up far more assets
from the private sector than it needs to keep the interest rate at
zero. The surplus cash does not push rates into negative territory
(for all intents and purposes, impossible). Instead it results in much
more cash in the economy, and a big increase in the bank's assets.