Greg Ip writes that the Federal Reserve now thinks that it cannot effectively peg the ten-year bond rate without moving very very carefully to control expectations about its projected path for short rates:
WSJ.com – Fed’s Next Interest-Rate Cut
May Be Smaller Than Expected: …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?
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…
Clearly I need to read Barry Eichengreen and Peter Garber, “Before the Accord: U.S. Monetary-Financial Policy 1945-51”…
I love the notion that why would anyone borrow money from anyone when the governemnt is giving it away for free? There is just not a lot of wiggle room to get out of this economy. If everything goes perfectly, maybe we will be fine by 2005. If there is any mistep, it could be a lot longer.