Fed may cut interest rates even more
The Federal Reserve is widely expected to cut interest rates again — and might even cut all the way to zero — to revive the...
The Associated Press
The Federal Reserve is widely expected to cut interest rates again — and might even cut all the way to zero — to revive the economy. A 0.5 percentage point cut is expected at the central bank's Dec. 15-16 meeting, which would bring the target to 0.5 percent. That's the lowest level ever based on Fed records that begin in 1990.
Michael Feroli, a U.S. economist at JPMorgan, says fears of deflation will prompt a cut to zero by the Fed's Jan. 27-28 meeting. That rate will be held through 2009, he says.
Deflation, a recurring decline in prices, is rare but damaging to the economy and tough to get rid of. Consumers postpone spending as they expect prices to drop. This stunts economic growth, forcing companies to cut more jobs, which further pressures spending.
Low rates can stimulate economic growth. By making capital cheaper for banks, the Fed hopes they'll lend more, and encourage spending by consumers and businesses. So far low rates haven't done the trick; credit remains tight amid the financial crisis.
Moody's Economy.com economist Ryan Sweet says another Fed cut might not help much since the effective "real world" rate is already below the target.
The Fed's many liquidity programs are making the rate hard to control, says IHS Global Insight economist Brian Bethune. "These are not normal operating conditions," he says.
If the rate goes to zero, the Fed loses a key weapon in its arsenal. Sweet thinks it might first announce plans to keep the rate low for an extended period, with the aim of reducing long-term Treasury yields. This could push down rates on mortgages and other loans.
Sweet notes a zero percent federal funds rate would make it difficult for money-market funds to offer competitive yields. As a result, investors could pull money out of banks — which is not what the Fed wants, Sweet says.
I'm not sure I understand, though. I thought the FED's new policy of paying interest on reserves established a floor for overnight borrowing rates? If they drop the FED rate to 0bps and continue paying interest on excess reserves, what are the consequences?
From the October 6th, 2008 FED press release:
Interest on Reserves
The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008.
Employing the accelerated authority, the Board has approved a rule to amend its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve balances (that is, balances held to satisfy depository institutions’ reserve requirements) and on excess balances (balances held in excess of required reserve balances and clearing balances).
The interest rate paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee over each reserve maintenance period less 10 basis points. Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector.
The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points. Paying interest on excess balances should help to establish a lower bound on the federal funds rate. The formula for the interest rate on excess balances may be adjusted subsequently in light of experience and evolving market conditions. The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.
The Board also approved other related revisions to Regulation D to prescribe the treatment of balances maintained by pass-through correspondents under the new rule and to eliminate transitional adjustments for reserve requirements in the event of a merger or consolidation. In addition, the Board approved associated minor changes to the method for calculating earnings credits under its clearing balance policy and the method for recovering float costs.
The revisions to Regulation D and the other changes will take effect on Thursday, October 9, 2008. The Board recognizes that depository institutions may choose to adjust their typical liquidity management practices in light of the payment of interest on required reserve balances and excess balances; the primary credit program and other Federal Reserve liquidity facilities are available to help institutions meet temporary funding requirements.
The Board’s notice of its actions regarding the amendments to Regulation D and associated changes is attached. While the action is effective immediately, the Board will accept public comments until November 21, 2008, and the proposal will be published in the Federal Register shortly. The Board will adjust the rule as appropriate in light of comments.
I'm trying to digest all this and would love to have input from any and all willing.