The Federal Reserve has not made explicit its embrace of quantitative easing or said that it is abandoning the nominal federal funds rate as its main policy instrument. But it is injecting huge volumes of extremely low-cost, short-term cash into the banking system. While the official federal funds rate stood at 1% last month, the actual rate at which banks received overnight federal funds was closer to 0.3%, as the Fed’s balance sheet ballooned from $800 billion in late September to more than $2.4 trillion in November.
So, even as private sector US growth estimates grew ever more pessimistic last month, and expectations mounted that the Fed would cut official rates by another 50 basis points this month and that nominal rates could be zero early next year, market participants might soon have to accept that the official federal funds rate is an irrelevance.
It is already for corporate borrowers and consumers. Credit spreads have risen, even as nominal rates have fallen, leaving the cost of borrowing high and the high hurdle rate from any debt-funded capital investment or asset purchase deterring borrowing and spending. Worse, this is only a consideration at all where credit is available at any price. Data from the Federal Reserve show bank-lending growth turning negative in the second two weeks of November, even as the Fed began paying banks interest on their excess reserves. Meanwhile new-issue volume in the securitization market – a source of more than $250 billion of funding per quarter up until midway through 2007 – now stands at almost zero. Flooding the banks with cash won’t achieve much if they don’t lend it to anyone.
So, as fears of deflation return – which would have dire consequences for borrowers forced to refinance and repay debt principal of rising real value – what other extraordinary measures might the Fed deploy next?
Federal Reserve chairman Ben Bernanke has outlined these before, notably in a 2002 speech to the National Economists Club in Washington, DC. This then is what he will be considering as his next steps, should he see signs of deflation becoming established.
First, he might announce that the Fed will hold overnight interest rates at zero for a specified period in the hope of bringing down rates along the term structure. This is what the Japanese did at the start of this decade. In his 2002 speech, however, Bernanke expressed a preference in such dire circumstances for imposing a cap on rates of longer-dated treasuries – starting with two-year notes and progressing maybe even to three-year to six-year notes. How would the Fed enforce such a cap? By committing itself to unlimited purchases of Treasury securities to bring the yield down to the target level.
The notion of the US Treasury issuing huge volumes of debt to the Fed sounds like an exercise in futility. Bernanke points out that the Fed successfully operated this policy for 10 years before 1951 and was able to peg rates on longer-maturity government bonds without actually owning more than 10% of the Treasury debt stock at times, although it did own most of the outstanding three-month bills. But in a broken financial system it’s not clear what a lower treasury yield curve would achieve.
If even that fails, the Fed might consider extending large volumes of zero-interest rate loans of 90 days or even 180 days to banks, secured against corporate bonds or commercial paper of comparable maturity, in an effort at driving down the rate on these term loans to corporates through Fed lending at a slight remove.
Are we thinking the unthinkable yet? How about the Fed buying more, or lending free money against collateral consisting of foreign-currency government bonds of other nations: a variant of what Franklin D Roosevelt did between 1933 and 1934 by printing paper money and buying gold?
It’s probably to his credit that Bernanke even managed to get the words out back in 2002. Let’s hope that deliberately cratering the dollar is very much his last resort and one we never see.
An even larger policy question now hangs over Bernanke’s deliberations. As he well knows, the best protection against deflation is to have a healthy and well-capitalized banking system and a smoothly functioning capital market. As he also well knows, the US has neither. All these extraordinary policy measures might yet prop up a fundamentally rotten system that needs to crash and be rebuilt. The challenge is to buy time for the financial system and the economy to restructure in ways that are not unbearably painful for a large proportion of the population.
Meanwhile, right now, US TIPS are pricing in no expectation of inflation for the next 10 years.
Perhaps this is precisely the time to go long of inflation.