The Fed Fixes Bayonets

Interest rates are close to zero as the Fed promises more unconventional measures.

Central bankers ordinarily strive to be boring. But these are not ordinary times. On Tuesday December 16th the Federal Reserve abandoned any pretence of business as usual and promised an all-out assault on the recession and the credit crunch.

After a two-day meeting the Fed’s policy panel, the Federal Open Market Committee (FOMC), announced three big measures: it has cut its target for the federal-funds rate to between zero and 0.25 percent, the lowest on record; it said that a weak economy would probably keep it there “for some time”; and having exhausted its conventional monetary ammunition, it promised a range of unconventional strategies, primarily purchases of mortgage-related securities and possibly Treasuries to push down long-term borrowing costs. Having run out of interest-rate bullets, the Fed has now fixed bayonets.

Alone, any of these steps would be momentous. Taken together they represent a formidable display of monetary aggression. That said, there is less than first meets the eye. Although the cut in the target for the federal-funds rate was larger than expected, it will have no measurable impact on the actual funds rate, which is charged on excess reserves lent overnight between banks. It had already fallen to around 0.1 percent, in anticipation of a target cut and because the banking system is awash with almost $800 billion of reserves. (The FOMC’s move to a range rather than point target for the funds rate reflects the difficulty it has had hitting that target.) The Fed had announced on November 25th that it would buy up to $100 billion of debt directly issued by Fannie Mae and Freddie Mac, the now-nationalised mortgage agencies, and $500 billion of their mortgage-backed securities (MBS). And in a speech on December 1st Ben Bernanke, the Fed chairman, had said that Treasury purchases were under consideration.

The Fed did not go much beyond any of that in its statement. However more important than specifics, and of greatest significance to the stockmarket, which soared on the announcement, was the assurance of radicalism. “The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” it said in its statement.

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Whether it will be enough remains the biggest question. The Fed has succeeded in bringing previous recessions to an end by cutting short-term interest rates. But now having cut the funds rate as low as it can realistically go, that is in doubt. Its new, unconventional operations have been dubbed “quantitative easing” because their effect is felt through the Fed’s control over the quantity rather than the cost of credit. Through the creation and expansion of an array of lending programmes, the Fed’s balance has grown from below $900 billion to more than $2 trillion. Such programmes have kept the interest rates charged to private borrowers lower than they otherwise would be, but the effect has been difficult to detect, and certainly smaller than what the Treasury achieved through direct injections of public capital into banks.

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