As Rates Near Zero, the Fed Turns to Unproven Methods

[Matter-Eater Lad]

WASHINGTON — Having printed more than $1 trillion in new money since September, yet still failing to stop the economy from sinking, the Federal Reserve is expected to enter a new era of cheap money this week.

 

On Tuesday, policy makers are expected to lower their target for the overnight federal funds rate to 0.5 percent, a record low.

 

In itself, analysts said, the move will be anticlimactic. Because demand for interbank loans has been so low, the actual Fed rate has been close to zero for a month. The real change will be in how the Fed tries to fight the recession from here on.

 

After Tuesday, the Fed will have to resort to mostly untested tools for promoting growth, because it cannot reduce its benchmark interest rate below zero.

 

Its goal will be to drive down borrowing costs wherever credit markets remain paralyzed. But the approach is much more complicated than raising or lowering a single rate, and it could have unintended consequences.

 

Analysts say the current recession, which officially began a year ago, is all but certain to break the postwar record for duration, 16 months. But it could also set a record for depth.

 

The economy has already lost two million jobs this year. Analysts predict that unemployment, now 6.5 percent, could hit 9 percent by the end of next year.

 

The Fed must now turn to an approach called “quantitative easing,” because it involves injecting money into the economy rather than aiming at an interest rate. The Fed has almost no experience with this approach.

 

“This is a whole new world,” said Richard Berner, chief economist at Morgan Stanley. “You don’t have a whole lot of historical precedent for knowing how this is going to work and what the unintended consequences could be.”

 

The risks include provoking inflation or yet another speculative bubble. Economists generally agree that the Fed’s long stretch of easy money from 2001 through 2004 contributed to the bubble in housing prices and the surge in reckless lending.

 

For now, neither Fed officials nor most private economists see evidence of inflation or a bubble. If anything, forecasters are worried about the kind of deflation Japan experienced in the 1990s.

 

Indeed, the Japanese central bank used quantitative easing for years when Japan was mired in chronic price deflation and had reduced its benchmark interest rate to zero. The results were not good, and it took Japan nearly a decade to break out of the mire.

 

Although Fed officials have denied it, they actually began a form of quantitative easing months ago. Since the financial crisis erupted in August 2007, the Fed has created a raft of new lending programs that have lent hundreds of billions of dollars to banks, Wall Street firms and money market funds.

 

Until three months ago, the Fed financed that lending with its existing reserves, mostly Treasury securities. Because it was simply exchanging its cash or Treasury securities for hard-to-sell securities, the programs did not increase the total amount of money in the financial system.

 

But since September, when the Fed started to run low on Treasuries, it has been creating new money at a blistering pace. As a result, the Fed’s “balance sheet” has ballooned to just over $2 trillion last week from about $900 billion in September.

 

http://www.nytimes.com/2008/12/15/business/economy/15fed.html?_r=1&ref=business