Economists on the new US Zero Interest Rate Policy (ZIRP)
The effort in the US to get credit flowing again
By Jon Fernquest
The US central bank (The Fed) surprised the
financial world yesterday by launching a Zero Interest Rate Policy (ZIRP)
to get credit flowing again and avoid deflation.
The economics blogosphere has been buzzing with commentary by leading economists on this latest move by the Fed. Here is a wrap up of some of the most important commentaries:
The Fed is now trying to keep the fed funds rate for interbank lending within a range slightly above zero: 0.0% to 0.25% (targeting a range) (Read Fed Announcement and explanation of range choice from Fed press conference).
The currencies of other countries such as Thailand will likely appreciate against the dollar if their central banks do not respond by cutting interest rates or printing money (quantitative easing). In fact, yesterday the Euro experienced the greatest single day appreciation against the US dollar (4 cents) since the Euro came into existence in 1999 (Read article).
Currency appreciation makes a country's exports more expensive and less competitive on international markets, a situation that Thailand saw last year in 2007 when its currency was appreciating. Pressures on the Thai central bank to depreciate the baht similar to those in 2007 could arise once again (Read analysis by economist Simon Johnson).
Since exports are an important part of Thailand's economy, the Bank of Thailand is likely to cut interest rates once again in response to the Fed's move yesterday (Read Bangkok Post article).
a wrap up - a
summary of things that have happened (or things people said)
the blogosphere - the writing in all the blogs on the internet
deflation - when the overall level of prices in an economy decreases
Zero Interest Rate Policy (ZIRP) - when a central bank has an effectively zero interest rate (for interbank lending)
federal funds - the balance kept by US banks at the US central bank (The Fed)
federal funds rate - the interest rate used by US banks when they lend their federal funds to other banks, this interest rate is used by the US central bank to control the money supply and availability of loans (credit) in the economy
overnight federal funds rate - the interest rate for banks borrowing federal funds to meet reserve requirements
interbank lending - money lent between banks to meet reserve requirements:
a press conference - when the government or a company holds a special meeting to announce important news to reporters
quantitative easing - when short-term interest rates are near zero and traditional central bank methods can't do anything to help the economy
appreciate, a currency appreciates (verb) - when the currency of a country increases in value compared with another currency (most commonly the US dollar)
appreciation, currency appreciation (noun) - a currency increasing in value
depreciation (noun) - a currency decreasing in value
the blogosphere - the writing in all the blogs on the internet
deflation - when the overall level of prices in an economy decreases
Zero Interest Rate Policy (ZIRP) - when a central bank has an effectively zero interest rate (for interbank lending)
federal funds - the balance kept by US banks at the US central bank (The Fed)
federal funds rate - the interest rate used by US banks when they lend their federal funds to other banks, this interest rate is used by the US central bank to control the money supply and availability of loans (credit) in the economy
overnight federal funds rate - the interest rate for banks borrowing federal funds to meet reserve requirements
interbank lending - money lent between banks to meet reserve requirements:
"Banks are required to hold an adequate amount of liquid assets [can sell quickly], such as cash, to manage any potential withdrawals from clients. If a bank cannot meet these liquidity requirements, it will need to borrow money in the interbank market to cover the shortfall. Some banks, on the other hand, have excess liquid assets above and beyond the liquidity requirements. These banks will lend money in the interbank market, receiving interest on the assets." (See Wikipedia)
targeting a range - acting to keep a certain measurable statistic within a certain rangea press conference - when the government or a company holds a special meeting to announce important news to reporters
quantitative easing - when short-term interest rates are near zero and traditional central bank methods can't do anything to help the economy
appreciate, a currency appreciates (verb) - when the currency of a country increases in value compared with another currency (most commonly the US dollar)
appreciation, currency appreciation (noun) - a currency increasing in value
depreciation (noun) - a currency decreasing in value
Recession + Deflation or Recession + Inflation?
In the US last month inflation experienced one of its steepest drops since 1933. The costs of many goods and the cost of living has been falling: "The cost of fruits, vegetables, clothing and vehicles are all dropping. Housing prices have been falling for more than two years, and a barrel of oil costs about $45, down from $145 in July."There are fears that prices could continue to drop at this fast rate creating a deflationary spiral. Practically speaking oil can't drop another $100 and OPEC moved to cut production today so a deflationary spiral is unlikely. (Note: In Thailand some agricultural commodities cannot be imported and the price is set at a fixed level so this would also seem to limit deflation.)
cost of living - the
cost of the typical set of goods purchased by a household (measured by
the consumer price index (CPI))
deflationary spiral - when decreases in prices lead to lower production which in turn leads to lower wages and demand which leads to further decreases in prices and the cycle repeats over and over again (See Wikipedia)
deflationary spiral - when decreases in prices lead to lower production which in turn leads to lower wages and demand which leads to further decreases in prices and the cycle repeats over and over again (See Wikipedia)
If the cost of living is likely to fall, at least in the US household incomes are not likely fall because wages are usually sticky in a recession: "most businesses simply will not cut their workers’ pay, even in a downturn. Businesses routinely lay off 10 percent of their workers to cut costs. They almost never cut pay by 10 percent across the board."
Also during a recession businesses typical give only "meager pay increases, increases that are even smaller than the low rate of inflation that's typical during a recession." Businesses avoid reducing pay because the negative effective effect on worker attitudes which could reduce the quality and productivity of work being done. (Read NY Times on deflation and Nouriel Roubini on stag-deflation at Project Syndicate).
If the Fed manages to avoid deflation and get inflation moving again there is the risk that inflation will shoot up too quickly and cause painful cost of living increases for households in the US.
sticky wages - wages
that generally do not move downwards much
across the board - including all cases
meager - very small, very little
productivity - producing more with the same resources and number of workers
worker attitudes - whether workers are motivated and want to work with their employer and be productive
across the board - including all cases
meager - very small, very little
productivity - producing more with the same resources and number of workers
worker attitudes - whether workers are motivated and want to work with their employer and be productive
Fed balance sheet as policy instrument
Anyway,
the fed funds rate is only one policy instrument that the Fed uses. The
Fed balance sheet is about to rise in importance as a policy instrument
but it is not exactly the "quantitative easing" or "printing money"
that everyone is talking about. During the Fed's press conference
yesterday the question was raised:Is this
quantitative easing?
The Fed said in its statement today that it will be using its balance sheet to support credit markets and the economy. Some analysts have called the approach quantitative easing — effectively expanding the money supply once interest rates cannot be eased further — as Japan did during its economic turmoil.
But the senior Fed official said the central bank’s approach is distinct from quantitative easing and different from what the Japanese did. The Fed’s balance sheet has two sides, the official explained: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan’s quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed’s focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. That’s designed to improve credit-market functioning, the official said. By expanding the balance sheet by making loans, the official explained, the focus is not on excess reserves but on the asset side. That securities-lending approach directly affects credit spreads, which is the problem today — unlike Japan earlier, where the problem was the level of interest rates in general, the official said. (Source: Real Time Economics Blog, Wall Street Journal, 16-12-08, link)
The Fed said in its statement today that it will be using its balance sheet to support credit markets and the economy. Some analysts have called the approach quantitative easing — effectively expanding the money supply once interest rates cannot be eased further — as Japan did during its economic turmoil.
But the senior Fed official said the central bank’s approach is distinct from quantitative easing and different from what the Japanese did. The Fed’s balance sheet has two sides, the official explained: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan’s quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed’s focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. That’s designed to improve credit-market functioning, the official said. By expanding the balance sheet by making loans, the official explained, the focus is not on excess reserves but on the asset side. That securities-lending approach directly affects credit spreads, which is the problem today — unlike Japan earlier, where the problem was the level of interest rates in general, the official said. (Source: Real Time Economics Blog, Wall Street Journal, 16-12-08, link)
balance sheet - a
written statement that shows the financial state of a company at one
point in time, lists the companies assets, liabilities (money owed),
and the value if the owner's interest in the company (equity)
is distinct from - is different from
credit facilities - different arrangements (contracts, agreements) used to borrow money
mortgage-backed securities - several home loans combined into a security that can be bought and sold like a stock
liabilities - money borrowed by a company (liabilities + owners' equity = assets)
bank reserves - a certain percentage of deposits that a bank does not lend out but keeps at the Fed for safesty (in case deposits start shrinking and need to be paid off)
excess reserves - increasing bank reserves to protect against an emergency (bad loans or shrinking deposits)
agency debt - debt by large semi-government agencies such as Fannie Mae and Freddie Mac which purchase home loans
commercial paper (CP) - debt issued without collateral by corporations to meet short-term financing needs (maturities ranging from 2 to 270 days)
swaps with foreign central banks - US dollars that the Fed supplies foreign banks that are facing a shortage of dollars
credit spreads - differences between interest rates charged on loans
is distinct from - is different from
credit facilities - different arrangements (contracts, agreements) used to borrow money
mortgage-backed securities - several home loans combined into a security that can be bought and sold like a stock
liabilities - money borrowed by a company (liabilities + owners' equity = assets)
bank reserves - a certain percentage of deposits that a bank does not lend out but keeps at the Fed for safesty (in case deposits start shrinking and need to be paid off)
excess reserves - increasing bank reserves to protect against an emergency (bad loans or shrinking deposits)
agency debt - debt by large semi-government agencies such as Fannie Mae and Freddie Mac which purchase home loans
commercial paper (CP) - debt issued without collateral by corporations to meet short-term financing needs (maturities ranging from 2 to 270 days)
swaps with foreign central banks - US dollars that the Fed supplies foreign banks that are facing a shortage of dollars
credit spreads - differences between interest rates charged on loans
Reduce "spreads" on loans is the name of the game
Economist Alan Blinder says the magic word of advice is "spreads."Spreads means the huge difference in interest rates between risk-free loans by the Fed and risky loans made by regular banks:
..the rates at which real borrowers borrow and real lenders lend -- now range from high to prohibitive. If we are to get credit flowing again, the spreads must come down -- a lot. When the Fed buys commercial paper, guarantees GSE debt, or backs asset-backed securities, it is trying to reduce the spreads on each of these instruments over Fed funds or Treasuries. It should keep doing that. (Source: Alan Blinder)
Investors
are shunning risk-taking of any kind and parking their money in risk
free short-term US government debt (T-bills or treasuries). As a result
the interest rate or return paid on this debt has dropped to zero. (See
graph of three month maturity treasuries on right). It no longer really matters how low the federal funds interest rate for banks borrowing from other banks is if the banks are not willing to loan money to businesses and households in the real economy. When the central bank monetary policy becomes ineffective like this it is called a liquidity trap.
liquidity trap -
when short-term interest rates are near zero and the central bank can't
do anything to help the economy
Fed not yet a risk-taker
Also from the Fed press conference yesterday:Could the Fed move down
the credit spectrum to target lower-quality credit?
Yes, but only if the Treasury Department is assisting, the official said. The Fed’s role is to lend against good collateral, not to take on credit risk. Developments will depend on discussions between the Fed and Treasury, the official said.
Yes, but only if the Treasury Department is assisting, the official said. The Fed’s role is to lend against good collateral, not to take on credit risk. Developments will depend on discussions between the Fed and Treasury, the official said.
