September 17, 2004


Fed moves rates with words rather than actions (JOSEPH REBELLO, September 17, 2004, Chicago Sun-Times)

The unusual strategy adopted by the Federal Reserve in the summer of 2003 for stoking the U.S. economy without cutting interest rates was a clear success, researchers at the U.S. central bank have concluded in a new study.

The study, led by Fed Governor Ben Bernanke, says the central bank managed to exert powerful effects on interest rates merely by promising to keep the key short-term federal funds rate low for a ''considerable period.'' Those influences were at least five times stronger than the average effect of actual interest-rate changes since 1991.

The study was posted on the Fed's Web site last week.

By July of 2003, the Fed had dropped the federal funds rate to a 45-year low of 1 percent without generating what it could consider a ''sustainable'' economic recovery.

The policy-makers decided at that point to stop cutting interest rates. They switched instead to a strategy that Bernanke and his colleagues call ''policymaking by thesaurus.'' For the first time in its history, the Fed began to make public statements about how it might change interest rates over a horizon beyond six to eight weeks.

The problem though is that, given the deflationary cycle we're in, the fed funds rate should have been lowered.

Posted by Orrin Judd at September 17, 2004 11:00 AM

Wouldn't things get tricky if he lowers it from 1 percent (!) and then really needs to lower it again? We can't have a negative federal funds rate, can we? It seems like he's just keeping a little margin for prudence.

Posted by: PapayaSF at September 17, 2004 12:41 PM


Why not? Japan has had negative rates during its deflation. A 1% rate during a time when inflation is -.5% is higher than an 18% rate when inflation is running 17%.

Posted by: oj at September 17, 2004 12:45 PM

If he had cut the Fed Funds rate much further from 1%, money market funds wouldn't have been able to cover their expense ration, and they would have dropped below $1.00 a share. There were stories a year ago saying "Oh, no, this wouldn't really be a problem", but people in the business tell me it would be.

Posted by: Dan at September 17, 2004 2:54 PM

This isn't my area of expertise and I may be nitpicking, but isn't your example a negative effective rate? I'm talking about an actual negative rate. Wouldn't an actual negative rate of (say) -1% be the government borrowing $100 and promising to pay back $99 later on?

Posted by: PapayaSF at September 17, 2004 3:31 PM

The rate in purchasing power terms is called the real interest rate. The rate in dollar terms is the nominal interest rate.

If nominal interest rates are negative investors will do better by holding cash than lending, because cash has a nominal inerest rate of zero.

As a practical matter, nominal int. rates therefore do not go below zero. (Yes I know there are exceptions when nominal rates are, like, -.01% for reasons like convenience of holding govt debt. but the lower limit is either exactly zero or very close to it.)

Posted by: Tom at September 17, 2004 4:43 PM

In case the thrust of that isn't clear: PapayaSF is basically right.

By the way, if the Fed ever found itself needing to stimulate with nominal rates already around zero, it could still keep expanding the money supply. This would have a stimulative effect on the economy, just not through an interest rate lowering mechanism.

Posted by: Tom at September 17, 2004 4:46 PM

No, Japan has recently run actual negative rates:

Posted by: oj at September 17, 2004 5:20 PM

Isn't Ben Bernanke, the Fed Governor who led the study, a possible Greenspan successor ?

US Rep. Ron Paul, (R-TX), believes that the CPI understates inflation, rather than overstating it. His argument is that because the CPI tracks rents, and not home prices, it appears as though housing costs are lowering, when in fact there's been tremendous appreciation in the price of homes over the past decade.

Larry Kudlow believes that the rise in the price of gold and other commodities is an inflationary signal.

Posted by: Michael Herdegen at September 17, 2004 7:01 PM

Paul is a nitwit and Kudlow a goldbug.

Posted by: oj at September 17, 2004 7:14 PM

You post a lot of Kudlow articles, so I assume that you believe that he's often right. Perhaps he is this time, as well.

According to economist Brad DeLong, in 'Why We Should Fear Deflation', it's not unknown for wages to increase during a period of general deflation.
If that's true now, it would push up home prices, and how are doubled home prices not inflationary ?
It's a classic case of too much money chasing too few goods.

Posted by: Michael Herdegen at September 18, 2004 6:25 AM