Fed

Buried in this weekend’s news was a report on the internal analysis being undertaken by the Federal Reserve Board with respect to its ongoing efforts to stimulate the economy. One of the more interesting nuggets is the calculation that, given the state of the economy right now, especially the balance between inflation and unemployment, the Fed should be setting its benchmark overnight interest rate, the Fed Funds rate, at -5%. Yes that’s minus 5%.

Since interest rates cannot go below zero that presents quite a difficulty!

But, ever the innovative crowd, the Fed has come up with all sorts of tricks to provide monetary stimulus even though its primary weaponry has been rendered useless.

They have undertaken a slew of actions, such as buying Treasury bonds and holding them in a portfolio, that are collectively called ‘quantitative easing’ or unconventional monetary policy.

The net objective of lowering interest rates is, of course, to stimulate the economy by making borrowing more attractive and simultaneously easing the cost of debt burdens. An increase in lending that results from lower interest rates causes a flood of money, i.e. the lent cash, to enter the economy. This additional money then greases the economic wheels, and activity rises. or so the notion goes.

When interest rates are so low that they cannot be lowered to generate this stimulus effect the Fed has to resort to its irregular bag of tricks. Its acquisition of Treasury bonds also is a way of pushing money into the economy since the cash its uses to buy the bonds is now in the hands of the former bondholders who can now use it for something else.

So we should all applaud the Fed for being willing to undertake all these unusual actions: its aggression is helping offset the timidity of the politicians who passed a relatively small fiscal stimulus. Small that is relative to the size of the problem.

So overall I give the Fed a high grade for its efforts.

But that -5% should grab our attention. If that is the ideal interest rate for the moment we can immediately sense the depth of our continuing crisis. Given that a target Fed funds rate in ‘normal times’ might be 3% to 4%, the Fed would have to raise rates by 8% to 9% to get back to ‘normal’. Such a run up in rates would be unbelievably restrictive: it would kill any chance of recovery and then some. So we can infer from the -5% that interest rates are going to be low, maybe even zero, for quite some time. I would guess that, barring some dramatic event, we will not see Fed funds much above zero for the next two years at least.

Naturally there are huge risks associated with all this unconventional policy and the extent of the monetary stimulus. In particular we have to be careful not to prime a surge in inflation. I don’t see this as a problem right now since the economy is operating so far from capacity: all that cash will be put too use closing the gap between where we are now and our capacity limitations.

One last thing: since no one really knows just when this monetary easing will show up as inflation, it is good to see the Fed is already planning its ‘exit strategy’.

Still: minus 5%. That seems a little ridiculous doesn’t it?