Why the Fed's Zero Interest Rate Policy Isn't Working

Slightly more than a decade ago, I spent many hours at the Bank of Japan talking with officials about the paradoxes of ultra low rates. At the time, BoJ officials faced intense pressure from politicians and markets to boost growth; so they were duly implementing quantitative easing or their zero interest rate policy.

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However, the more they experimented with Zirp, the more skeptical they seemed about whether it really worked. The essential problem, they moaned, was that Japan’s financial system was so broken that it had become bifurcated: some companies desperately needed cash, but could not borrow because the banks were too risk-averse to assume credit risk, with or without Zirp.

However, healthy companies that did not need loans were finding it laughably easy to raise money. The result was a classic liquidity trap. And, as such, it left men such as Masaru Hayami, then serving as BoJ governor, privately joking that he really ought to raise rates – not cut them – since that, at least, would make long-suffering savers happy.

These days, the shadow of Japan is hanging over America’s Federal Reserve (and not just because when Ben Bernanke was an academic, he used to write extensively on Zirp, and question whether Hayami was trying hard enough). Last week, the Fed announced the latest variant in its home-spun version of Zirp: the so-called ‘Twist’ operation, a move that sees it purchasing long-term bonds and mortgage securities, in place of short-term term debt and government bonds.

This aims to lower long-term borrowing costs, and thus supply more credit to the business sector and mortgage world.

But, the Fed’s problem – like Japan a decade ago – is as the International Monetary Fund puts it in its latest financial stability report, the economy is “bifurcated”. Many large American companies, particularly those with global operations, are highly profitable and liquid. Unsurprisingly, for them “bank lending conditions and capital market financing remain easy”, the IMF notes.

But many small and medium-sized companies – or the entities that typically create jobs inside America, not overseas – find it hard to raise funds. A survey conducted by the International Franchise Association in Washington, for example, notes that whereas in March half of its members expected credit conditions to improve soon, now less than a quarter expect any easing; even as Treasury yields fall.

There is bifurcation in the mortgage market too. On Thursday Freddie Mac announced that the average rate on a conventional fixed-rate 30-year mortgage had tumbled to an all-time low of 4.01 percent (and in western US regions, just 3.95 percent), following ‘Operation Twist’. Wall Street bankers are buzzing with tales of savvy financiers refinancing home loans at rock-bottom rates. But, as a report from the Institute of International Finance says, “in order to take advantage of lower mortgage rates, borrowers have to refinance their mortgages, which can be difficult to impossible, if the value of home equity has been eroded”. Twist, in other words, does nothing for households with negative equity (estimated to be about a quarter of the total); nor those in distress (another quarter.) Worse still, Fannie and Freddie are not allowed to refinance their loans. Little wonder that mortgage approvals are falling fastest in communities with high levels of negative equity and repossessions – precisely the area that the Fed wants to help.

Is there any solution? At the IMF meetings last weekend, proposals fell into three strands. Some voices, particularly in Europe, want regulators to “urge” the banks to lend, via targets or political pressure. Witness, for example, the calls made this week by the Financial Policy Committee in the UK (which also faces a bifurcation problem.) However, bank lobbyists retort that a better solution would be to water down efforts to tighten capital standards; according to the IIF, what is hurting credit provision is excessive regulation and uncertainty.

Meanwhile, some economists are now pressing the Fed and other central banks to get more directly involved in lending themselves. Alan Blinder, the former vice-chairman of the Fed, for example, likes the idea of the Fed purchasing more mortgage bonds, or even corporate loans; another proposal floating around is to securitize loans to small American businesses, which could then be purchased by the Fed, via another version of Twist.

Such ideas may help at the margins; purchasing securitized bundles of SME loans, for example, seems sensible. But none is a silver bullet, least of all when eurozone woes are making US banks even more risk averse. If Hayami were still alive today, it would be interesting to know what advice he would give; and even more interesting to know how Bernanke might respond.