naked capitalism

Bloomberg tells us that JP Morgan has issued a report that contends that the Federal Reserve will cut its policy rate to zero by early next year.

While this may prove to be correct, it certainly isn’t an obvious move. First, most central banks regard getting below 1% short term rates is dangerous territory. ZIRP (zero interest rate policy) let to a deflationary trap for Japan, and there isn’t a particularly good reason to think it will fare better here.

In addition, once short term rates fall below 1%, money market funds have trouble operating profitably. The Fed may find itself not merely acting as a big player in the commercial paper market (money market funds are big buyers of CP), but becoming the ONLY player. That would also not be good.

From Bloomberg:

The U.S. Federal Reserve will probably cut interest rates to zero percent over the next two months to staunch deflation, according to JPMorgan Chase & Co.

The Fed will lower borrowing costs by 50 basis points at each of the next two policy meetings on Dec. 16 and Jan. 28, JPMorgan economist Michael Feroli wrote in a note to investors yesterday. The central bank will hold rates at zero for the rest of 2009 to prevent prices from spiraling down as companies cut jobs and banks reduce lending, stifling spending, Feroli said.

The Fed may not be the only central bank to begin offering free money to jolt life into their recessionary economies and keep prices rising as the 15-month credit crisis deepens. The Bank of Japan cut its benchmark rate to 0.3 percent last month, and the European Central Bank has signaled it’s ready to lower rates further after two reductions in the past six weeks.

U.S. consumer prices plunged 1 percent last month, the most since Labor Department records began in 1947, the government said yesterday. Some Fed members indicated a willingness to cut rates to spur growth and keep prices from falling, according to minutes from the last Federal Open Market Committee meeting that were released hours after the price report.

“Taking the target rate to zero percent would not be costless for the Fed,” Feroli said. Public confidence may drop “if there is a perception that the Fed has `run out of ammo.”’

Fed officials cut their forecasts for inflation and growth at the Oct. 28-29 meeting. Some members saw a risk that the inflation rate will fall below the Fed’s objective of “price stability.”

Feroli said cutting the key rate to zero from the current 1 percent wouldn’t exhaust the central bank’s tools. The Fed could become “more aggressive” by purchasing the debt of Fannie Mae, Freddie Mac and other government-chartered mortgage financing companies, Feroli said.

“The path of least resistance may be for the Fed to first communicate to the markets that the nature of the current economic woes should keep rates low for an extended period,” Feroli said.

While not saying whether rates would be cut to zero, a Reuters story said that the minutes of the last FOMC meeting pointed to a desperation-driven willingness to drop rates below 1%. Persisting in a course of action that is not working is not a sign of intelligence. The Fed is clearly pushing on a string. Throwing its weight behind a big stimulus package before year end would be a much better way to boost the economy. If Fed funds at 1% and massive fancy facilities is not inducing banks to extend credit, a further reduction in policy rates won’t have any impact.

From Reuters:

The Federal Reserve seems almost guaranteed to wade into unchartered waters in December and cut its benchmark lending rate below 1.0 percent.

Unrelenting bad news on the U.S. economy, reflected most recently in minutes from the Federal Open Market Committee’s October policy meeting issued on Wednesday, suggest another interest rate cut is in the works, even as rates approach the so-called “zero bound.”

“Some members were already feeling that additional policy easing could be appropriate … given recent data and developments in financial markets, ’some’ may have turned into ‘most,” said Rudy Narvas, analyst at 4CAST Ltd in New York.

Short-term interest rate futures fully price a cut in the fed funds rate to 0.5 percent from 1.0 percent at or before the Dec 16 policy meeting.

The effective fed funds rate averaged 0.63 percent in May 1958, the lowest level shown by Federal Reserve Board records dating back to 1954.

The FOMC cut the rate to 1.0 percent in October, the latest move in an easing cycle that started in September 2007, when the funds rate was 5.25 percent, as the central bank attempts to pump life into the U.S. economy.

Sky-high futures prices also reflect ideas that the cash funds rate will continue to trade below the target rate. Cash fed funds last traded at 0.3125 percent.

Although some policy-makers have noted technical problems in cutting the target rate below 1.0 percent, opposition could melt away in the face of current economic reality…

Wednesday’s FOMC release included updated forecasts, assembled at the Oct 28-29 meeting, that pointed to a long if not necessarily deep economic recession.

“While some expected an improving financial situation to contribute to a recovery in growth in mid-2009, others judged that the period of economic weakness could persist for some time,” the Fed said.

The Fed lowered its “central tendency” forecast range for 2008 gross domestic product growth to between zero and 0.3 percent from June’s 1.0 to 1.6 percent. Some at the FOMC said the economy could shrink by 1.0 percent in 2009 with the jobless rate as high as 8.0 percent versus the current 6.5 percent.

Even those assessments, cobbled together in the final days of October, might need to be lowered given the recent labor market deterioration that will only feed the vicious cycle of negativity.

The negative 1% as worst case is also a tad optimistic. Countries that suffered financial crises as big as ours saw a fall in GDP of 1!% for two years running, and their crises did not occur in the context of a synchronized global slump.