The Fed's Zero-Interest Policy -- Tokyo on the Potomac

The Federal Open Market Committee has reduced the target fed funds rate to a range of zero to one-quarter of a percentage point, officially entering a very-close-to-zero interest rate policy. This policy is associated with the Bank of Japan since the Japanese stock market and real estate bubble burst in 1990, and especially the period 1999-2006 when the Bank of Japan's zero-interest-rate policy was officially in effect. The FOMC announced today:

A target range for the federal funds rate of 0 to 1/4 percent. Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.

Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

How does a central bank have any influence once it gets close to a zero-interest rate, when banks are reluctant to make loans and investors are trying to stay liquid because the economic environment looks unpromising and balance sheets are weak.

The Bank of Japan has pursued a policy of "quantitative easing," putting money into the economy through purchase of assets such as government securities. Since the 1950s the Federal Reserve has preferred to buy and sell very short-term Treasurys, but a quantitative easing policy would push purchases up into longer-dated debt. The FOMC has explicitly announced it might do this:

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters, the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities and as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

The FOMC says the Federal Reserve will employ "all available tools" but the truth is that the Fed is inventing new tools as it goes along. Former Fed Governor Larry Meyer has it right when he said that the Fed will do "whatever it takes" to try to get out of the current credit freeze. Meyer is speaking tomorrow at the New York Association for Business Economics, of which I was president in 2002-2003.

The FOMC action was unanimous among the ten members attending, two below full strength. Christine Cumming voted on behalf of the New York Fed, since Timothy Geithner is preparing to take over, if confirmed by the Senate, as President-elect Obama's Treasury Secretary. The New York Fed is the only Federal Reserve Bank whose representative always has a vote on the FOMC Board along with the Chairman and six other (when the Board is at full strength) Federal Reserve Board governors. Four of the other 11 Federal Reserve Banks are voting members of the FOMC on a rotating basis.