Wednesday, December 17, 2008

Fed reaches end of its traditional road

Business Times - 18 Dec 2008

From now, it may resort to other tools such as printing new money

By LEON HADAR
IN WASHINGTON

PUNDITS have been using a variety of dramatic adjectives - 'rare', 'unprecedented', 'extraordinary', 'radical', 'historic' - to describe the Fed's decision on Tuesday to cut its target for the federal funds rate to a range of zero to 0.25 per cent - a record low - from one per cent.

But in a way, in a year that has seen so many 'rare', 'unprecedented', 'extraordinary', 'radical', and 'historic' moves by the US federal government, including the partial and complete nationalisation of several banks and investment houses and the bailing out of many financial institutions, not to mention the long list of fiscal and monetary policies, the decision by the central bank to slash its benchmark interest rate close to zero was not only expected but somewhat anti-climactic, especially when one takes into consideration that the effective Fed funds rate, which is based on actual banking transactions, has already dropped to zero a while ago.

Against the backdrop of new reports that pointed to more bad economic news, including a dramatic decline in home construction and continuing fall in consumer prices, the Fed stated that it was willing to keep rates low for a long period and that it would apply 'all available tools' to assist in the recovery of the US economy and prevent a long and devastating recession.

In practical terms, the central bank may have reached the end of the line as far as its traditional monetary policy is concerned. The Federal Open Market Committee (FOMC) will not be able to announce another set of cuts in its next meeting in January next year, just as the new president is about to enter the White House.

That means that from now on, Washington would have to begin pursuing a more unconventional course of action to contain the clear and present danger of deflation and a continuing economic slump through an unprecedented form of fiscal policy - the trillion dollars or more in government spending, aka a stimulus package, under the Obama Administration, with the Fed pumping credit into the market in the hope of helping to reduce the cost of borrowing for businesses and consumers.

Hence, the Fed is expected to embrace a tool of monetary policy known as 'quantitative easing', meaning that it will print new money in order to increase its supply.

That was basically the policy adopted by the Bank of Japan to deal with its domestic deflation at the start of the decade.

In fact, the Fed has already started pursuing this policy in the aftermath of the collapse of Lehman Brothers and it will take several months for its effect to be felt in the markets as the Fed buys more mortgage-backed and consumer debt.

Policymakers and economists continue to debate whether the policy of quantitative easing - with the Bank of Japan, it flooded commercial banks with excess liquidity to promote private lending - had its desired effect on the Japanese economy or whether it may have created disincentives for the needed economic reforms in Japan.

In any case, the current conditions of the American and global economies are very different from the one that existed in Japan in 1999.

The combination of a gigantic economic stimulus package in addition to other government expenditures, and the printing and pumping of more US dollars by the Fed is bound to increase the budget deficit to new heights and put enormous downward pressure on the US currency.

That means that even if the fiscal and monetary policies pursued by Washington could prevent a Great Depression II, they could end-up creating new long-term structural problems for the American economy.


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