Fed Funds Rate: Looking At Zero

The current 1.5% Fed funds rate isn’t long for this world. The Federal Reserve, perhaps in coordination once again with other central banks around the world, will cut interest rates, and soon.

That, at least, is the market’s view. The November ’08 Fed funds futures contract has all but priced in a 50-basis-point cut to 1%. This announcement of a cut will come as a shock to no one, given the events of late.

Meanwhile, money supply has been rising at extraordinarily high rates in reaction to the extraordinarily dire state of affairs in finance and increasingly on the economic front. M1 money supply (the narrowest measure) surged more than 19% on a seasonally adjusted annualized basis for the three months through September 2008, the Fed reports. A year ago, M1 was up a mere 0.8% over the same time frame.

Such an aggressive creation of liquidity will be met with lower interest rates…again. But we’re coming to the end of this road, and the dangers (psychological as well as economic) are growing. It’s no longer beyond the pale to consider the possibility that the Fed will drop rates to zero, depending on how the turmoil unfolds in the coming weeks and months. What happens when Fed funds have sunk to nothing remains an open debate, but this future appears to be rushing toward us.

Moving monetary policy below the 1% rate is explored territory. In the 1950s, Fed funds briefly dipped below 1% and approached but never reached zero. What might happen this time if rates tested and bested those old lows is the stuff of speculation. A new era of monetary experiment, as Vincent Reinhart calls it, awaits. Outcome yet to be determined.

The U.S. isn’t alone in facing the potential of venturing into this strange, untested realm of monetary policy. Britain, to name but one of the other candidates looking at zero, is also facing the possibility of virtually giving money away.

Beyond zero, what are the options? Fed Chairman Bernanke explored the issue in a speech back in November 2002, when he was a Fed governor. The bottom line: there are alternative means of creating additional liquidity when rates are at zero, he explained.

As to how effective those alternative levers are, well, stay tuned. Moving into uncharted territory is inherently full of surprises, and not necessarily for the good, and so it’s unclear what we’re looking at if Fed funds go materially below 1% for any length of time. In some respects, the central bank is the last, best hope for keeping an economic system from imploding when debt threatens to overwhelm. We’re still a long way from deflation, but it’s not too soon to start thinking about the consequences.

Debt, in short, is the basic issue. The question of how to deal with it is as complex as the threat is simple.

About James Picerno 894 Articles

James Picerno is a financial journalist who has been writing about finance and investment theory for more than twenty years. He writes for trade magazines read by financial professionals and financial advisers.

Over the years, he’s written for the Wall Street Journal, Barron’s, Bloomberg, Dow Jones, Reuters.

Visit: The Capital Spectator

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