Several Rate Cut Scenarios and Lessons From Japan

October 28, 2008

Kathy Lien of GFT describes four rate cut scenarios for tomorrow: 1) a reprise of the October 8th coordinated round of Fed, ECB, and BOE rate reductions, 2) a 50-basis point ease by the Fed, 3) a 25-basis point Fed ease and 4) a 75-bp cut of the Fed funds rate. The market expects the second option, and so do I for reasons explained in an earlier post today. Lien’s analysis broaches two very interesting considerations, the first of which asks whether the dollar will respond differently to coordinated and unilateral rate cuts. She believes additional dollar appreciation is more likely if the ECB and Bank of England do not cut rates, too, presumably because unilateral monetary support will accentuate the contrast between a proactive FOMC and behind-the-curve monetary policy in Europe.

I doubt that any dollar advantage from the second scenario will be long-lasting. The ECB and Bank of England hold policy meetings on November 6th and will likely each cut their rates then by at least 50 basis points, matching and perhaps exceeding the Fed’s move. An eight-day delay between the two sets of meetings is not excessive and would enable European policymakers to know the result of the U.S. election and the market’s reaction to that result before they deliberate. More importantly, Europe will be making deeper rate cuts in the future than the Fed. The Fed has sliced rates already by 375 basis points, compared to cuts of 125 basis points at the Bank of England and 50 basis points by the ECB. The Fed funds target is 1.50% going into tomorrow’s FOMC meeting compared to target levels of 3.75% at the ECB and 4.5% at the Bank of England. Deflated by on-year CPI inflation, the nominal levels translate to inflation-adjusted target interest rate levels of negative 3.4% at the Fed, -0.7% at the Bank of England and positive 0.15% at the ECB. In fact, all of those levels overstate the real interest rate, since expected inflation over the coming twelve months is undoubtedly lower than actual inflation over the previous twelve months, but the relative ranking of these rates is not be affected by that technicality. Based on rate levels and accrued rate reductions made thus far, European central banks now need to ease more rapidly than the Fed, and that fact will continue to boost the dollar, whether the next round of rate cuts is coordinated precisely or staggered by a week.

The other issue raised in Lien’s article concerns how low U.S. rates might actually go. A reference is made to ZIRP, the acronym for zero interest rates, which Japan experienced in parts of 1999-00 and again from March 2001 to July 2006. As the Bank of Japan acknowledged belatedly, it is possible to ease monetary policy even when rates have already been reduced to zero, simply by switching from an interest rate target to an increasingly generous quantitative money growth objective. The BOJ’s principle policy sin was not in allowing rates to fall to zero but in moving to that point far too slowly. Japanese overnight money rates followed the following downward progression in end-of-year levels: 6.5% in 1989, 8.25% in 1990, 6.25% in 1991, 3.90% in 1992, 2.40% in 1993, 2.30% in 1994, 0.45% in 1995, 1996 and 1997, 0.25% in 1998, 0.0% in 1999, and 0.25% in 2000. A quarter-percentage point increase had been implemented prematurely in August 2000 even while Japan was experiencing deflation, and a reinstatement of ZIRP was made in March 2001 but this time accompanied by increasingly excessive levels of banking reserves. Quantitative easing was progressively escalated and not phased out until the spring of 2006. A 25-basis point hike in the overnight rate target was implemented in July 2006, followed by a second such move to 0.5% in February 2007, and that’s where things have stood for the past 20 months.

From a higher starting level, the Bank of Japan did not cut rates as deeply in 1991, 1992, or 1993 as has the Fed during the current easing cycle. BOJ policy inexplicably marked time in 1994 and again from 1995 until 2001 when quantitative easing was adopted. Japanese growth was never the same after the 1980’s. GDP had expanded 4.0% per annum for the ten years to 1991. Growth then slowed to 0.8% per annum in the three years to 1994, accelerated to 2.1% per annum during the ensuing three years to 1997, but slowed back to 0.4% per annum over the six years to 2003 when the government finally recapitalised banks, forced institutions to get rid of bad assets, and reliquified the banking system. Over the four and a quarter years to 1Q08, growth averaged 2.0%, still only half the pace of the 1980’s, and now the economy has once again relapsed into recession.

The two nightmares for the American economy are the Great Depression and Japan’s L-shaped business cycle since the early 1990’s. FED officials mustn’t let the money stock contract as it did in the 1930’s, but the greater risk is that it will not steer clear of a Japanese-type pattern. One lesson from Japan is not to conserve rate-cut ammo. There is nothing magical about zero. Policy can be loosened even after rates hit that level. A second lesson is that the trauma of extremely low interest rates seems to leave an economy with a dormant infection that prevents the economy from returning to normal interest rate levels on a sustaining basis. Japan hasn’t had its short-term rates above 0.5% since September 1995. In 2001-3, the Fed flirted with ZIRP, reducing its rates from 6.5% to 1.0% and keeping that ultra-low level until well into the ensuing economic recovery. The Fed managed to return its target rate to 5.25% only temporarily and now faces the conceivable prospect of eventually cutting rates to even sub-1% levels. The third lesson has implications for the dollar. Just because the Fed funds rate is poised to drop to 1% tomorrow doesn’t ensure that such is the end point. Few would in fact take that bet. And we do not know if enough monetary stimulus is in the pipeline to ensure a decent recovery by 2H09 or even to put the U.S. economy on a better footing then than Europe’s economy

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