Approaching Zero

The US Fed appears to have done the unthinkable – bring interest rates close to zero. Its actions seem to be aimed at kickboxing the economy out of doldrums. Monetary easing can be an effective tool to change the trajectory of economic growth, but such low levels of interest can prove dangerous. The US economy is not only in the throes of recession, but could also be headed for deflation. We all know that inflation can be fought by raising interest rates. Conversely deflation requires lowering of interest rates. But with interest rates hovering close to zero, a sub-zero interest rate is not feasible.

But let’s evaluate what a sub zero interest rate could mean. The pressure towards a sub-zero interest rate seems to indicate that more money needs to be pumped into the economy to lubricate its monetary wheels and get it rolling. The financial implosion leading to the collapse of biggies like AIG, Freddie and Fanny have left a psyche of extreme risk aversion in the financial world. Thus even at such low interest rates, borrowing and lending is very conservative. Such conservatism is not the likely solution for lifting the US economy out of recession.

The Fed seems to have found a way around and is indulging in what is known as quantitative easing. Central bankers use this technique when interest rates are near zero and they flood the financial system by pumping in cash via purchase of securities, mortgages, commercial loans from bankers’ books. Japan used this tool earlier this decade to combat deflation.

The Fed’s earlier announcement of buying up to $100 billion of Freddie and Fannie’s debt and $500 billion of their mortgage backed securities were steps in this direction. The Fed’s balance for such action has now reportedly grown to $2 trillion.

It is hard to determine if Fed’s actions are reaping benefits for the economy as yet. However, some light appears to be emerging at the end of the gloomy economic tunnel. The huge drop in oil prices is leaving consumers with more money to spend on consumer goods. November retails sales data revealed that consumer spending was not as weak as it was expected to be. A fall in mortgage rates is helping stabilize home sales and inter bank rates have also fallen. The Fed’s easy lending program also remained undersubscribed recently, with banks picking up only $63 million in short term loans against the offered $150 million, indicating that banks are stabilizing.

The immediate impact of lowering of interest rates by the Fed led to a weakening of the US dollar. As the yield on dollar based treasuries falls, investors would like to look for better yielding treasury paper of other nations and demand for other currencies should rise. This leads to a fall in the US dollar. However, depending upon how the global economic scenario unfolds, risk aversion could make investors run back to dollar denominated treasuries and lead to an appreciation in the dollar.

Whichever way the dollar moves, one thing is certain that interest rates in the US have almost bottomed out and cannot fall any much further!