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With Interest Rates Near 0%, What Does Fed Do Now?

Now that Fed Chairman Ben Bernanke has answered the question of how low he would take interest rates, he has some explaining to do about what's next.

“It's new ballgame with a new set of rules," says veteran Fed watcher David Jones of DMJ Advisors.

Ben Bernanke
Ben Bernanke

All of those rules, however, have yet to be made, and some speculate the Fed may have to make some of them up as it goes along.

For two decades, the Fed’s policy-setting committee, the FMOC, was basically about two things—a risk assessment about growth vs inflation and the direction of interest rates—actual and/or imagined.

“What was importantly left unsaid was what a new indicator of monetary policy is if the funds rate is left in the range of 0%-0.25%,” asks economist Ram Bhagavatula, managing director of the hedge fund Combinatorics Capital. “What is the real world consequence of any acts or measures they take?"

Those measures, from credit facilities to asset swaps to outright purchases of assets, are innovative by almost any standard and are therefore largely untested.

Though direct comparisons are difficult, economists recall the time in 1979 when then-Fed Chairman Paul Volcker essentially changed the central bank's primary monetary policy tool from interest rates to money supply, which created "total confusion”, says Jones.

So, come the conclusion of its next meeting in January, what does the Fed say and how does it signal its future intentions? Moreover, communicating its intentions, as well as managing market expectations, may be difficult, say analysts, especially for a Fed Chairman, who has occasionally stumbled in that area.

Video: CNBC's Steve Liesman talks about what the Fed does next.

For example, the Fed Tuesday once again said it is might buy long-term Treasuries to lower borrowing rates, in essence side-stepping banks, which have been reluctant to loan money, especially at favorable rates. Some interpreted that as a logical next step.

“If we are still seeing job losses in the 400,000 to 500,000 range at January's meeting, we would expect them to indeed buy Treasuries in substantial quantities,” says Bank of Tokyo-Mitsubishi economist Chris Rupkey.

If that thinking becomes market consensus, then what happens if the Fed doesn’t do that? What if, as some suggest, it’s a last ditch measure or just a way for the Fed to talk down the market, a new kind of jawboning, so to speak?

WALL STREET IN CRISIS - A CNBC SPECIAL REPORT
WALL STREET IN CRISIS - A CNBC SPECIAL REPORT

Moreover, not only is the idea a relatively radical one, no one knows how much money would be required and how much it would actually move rates. Much like currency market intervention, the move might be more psychological than anything else.

“You have to do an awful lot of buying to move rates,” suggests Robert Brusca, chief economist at fact & Opinion Economics. “Would a trillion dollars be enough?”

Given the all the unknowns, economists were already speculating on how to read the effectiveness of Fed policy and its goals in the new era.

One is credit spreads, and whether they narrow or widen. Another might be an expansion in the Fed’s balance sheet.

“Next meeting, I suppose they can tell us they've raised their balance sheet,” says Bhagavatula. Or the Fed could make a habit of characterizing credit spreads, must as it has with general credit conditions over the past year.

Even still, that’s unlikely to be adequate.

After Tuesday’s FOMC statement, the central bank made a senior official available to the media to answer questions, providing clarity and reducing uncertainty about its policy statement. Though that’s not as transparent as the European Central Bank’s practice of having chairman and vice chairman at a post policy-meeting news conference, it’s a highly unusual step.

"In this era where you are going to do different thing, you have to have a new way to communicate,” says Brusca.

Bernanke, a champion of greater institutional transparency, and his team appear to understand that is necessary. For now, its uncertain how far they'll go.

It's not out of the question that the next step in the Fed's communication strategy could be a post-FOMC meeting news conference—on the record.