With Rates Near Zero, What Will Fed Do Next?

The Federal Reserve is struggling to explain its plans for pulling the U.S. economy out of recession as it resorts to unorthodox policy tools while official interest rates are set near zero.

Since a rate-setting meeting in December, several U.S. central bank officials have tried to lay out what the Fed can do now that it has run out of conventional ammunition to support economic growth.

Usually, the Fed can focus its policy message around its interest rate target, but with federal funds already close to zero that capability has disappeared with no clearly discernible substitute on the horizon.

AP

"It is very difficult to communicate the nature and effects of unconventional balance sheet actions," Glenn Rudebusch, associate director of research at the San Francisco Federal Reserve Bank said in a report earlier this month.

Rudebusch suggested the Fed needs to explain what it hopes to achieve with its various new programs to ease conditions in specific credit markets.

The Fed's next chance will come on Wednesday, when its policy-making Federal Open Market Committee issues a statement following two days of deliberations. It will be the FOMC's first meeting since it cut the overnight federal funds rate to a range of zero to 0.25 percent in mid-December.

Some Fed watchers expect a commitment to buying long-term Treasuries, word on an expansion of the efforts to buy securities in other asset classes, or even setting of an explicit inflation target as as a way to tackle worries about deflation.

Still, the reactive nature of many of the Fed's moves since 2007, with programs seemingly created on the fly as fresh crises erupted, has made crafting a clear policy message more difficult, and also devalued the currency of the FOMC statement.

"The Fed has been making up plays at the line of scrimmage, rather than taking them from a playbook," said Brian Fabbri, economist at BNP Paribas in New York. "Thus the relevance and drama of the FOMC meetings—where the markets would anticipate and react to each change in the Fed's target rate—has been reduced."

Helicopter Days

The Fed is now providing huge amounts of liquidity and credit to various segments of the private sector, massively expanding the size of its balance sheet in what Chairman Ben Bernanke terms "credit easing" policy.

It has attempted to distance itself from Japanese-style "quantitative easing," when the Bank of Japan in the early 1990s set an explicit numerical target for reserves, and expanded reserves accordingly.

"The Japanese experience suggests that simply expanding bank reserves—even by a very large amount—had little effect on bank lending or on the economy more broadly," Janet Yellen, San Francisco Fed President and an FOMC voter this year, said on Jan 15.

Still, the Fed risks a communications gap because its "alphabet soup" of programs can not be be distilled into a simple message on its policy bias—easier, tighter, or no change—or easily measured for signs of success.

Chicago Fed President Charles Evans has defined the Fed's current actions as a proxy for doing the impossible, or setting the fed funds rate at a negative level.

"The trick, no doubt, would be to print exactly the right amount of money to fix today's economic problems without generating another disaster via hyper-inflation," said Rory Robertson, interest rate strategist at Macquarie Bank in Sydney.

But fine-tuning policy around a theoretical negative funds rate is tough, as then-Fed governor Bernanke acknowledged in a now-famous 2002 speech on deflation.

"Alternative policy tools ... may raise practical problems of implementation and of calibration of their likely economic effects," Bernanke said.

Bets in the derivatives markets suggest the Fed could start lifting interest rates as soon as September. Many forecasters look for a much longer spell of near-zero rates, given their gloomy economic outlook.

Jan Hatzius, economist at Goldman Sachs, said that by the end of 2010 conventional monetary policy drivers such as the Taylor Rule, which suggests appropriate adjustments to interest rates based on factors such as inflation and the jobless rate, would imply a fed funds rate of negative 6 percent.

"Our forecast of a 9.5 percent unemployment rate by late 2010 implies the largest amount of slack of the postwar period," Hatzius said. "Fed (and Treasury) officials will need to expand their efforts to stimulate demand dramatically further."

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