A Virtual Easing by the FOMC

January 25, 2012

The Federal Open Market Committee didn’t cut Federal funds rate because it’s already been near zero since late 2008.  New quantitative easing wasn’t announced because the present round of Operation Twist still has five months to run.  The third major policy tool after cutting interest rates and unconventional measures to increase liquidity and depress longer term interest rates involves communication, also known as jaw-boning expectations.

Without yet releasing its expanded quantitative forecasts or holding the press conference, the basic statement released at 12:30 EST went further than analysts were expecting in a number of ways:

  • The growth outlook calls for modest expansion, down from a moderate pace predicted at the prior FOMC meeting.
  • Guidance for the likely continuance of an exceptionally low federal funds rate, at or barely above zero, was extended 18 more months from a date of at least mid-2013, first postulated last August, to one of "at least late 2014."
  • This monetary policy stance was called "highly accommodative."

Since a second deflationary scare in less than a decade prompted the Fed to slash its short-term rate target to nearly zero at end-2008, many analysts have drawn parallels to Japan’s experience since the early 1990s.  Bursting asset bubbles in both economies had rendered financial markets dysfunctional first in Japan and later in the United States.  The Bank of Japan was first to implement zero interest rates in 1999, but the Japanese overnight money target had already fallen to as low as 0.5% by September 1995.  It has never exceeded that level since, and ZIRP has been employed in three stages, initially for 18 months in 1999-2000, then for five years from early 2001 until 2006, and again at present.  For Japan, the uninterrupted period with a central bank rate target of 0.5% or less now stretches out to 16-1/3 years, and the end of this period is realistically still not in sight.  For Japan, exceptionally low rates have become a quasi permanent status.

Could the United States face the same fate?  From December 2008 until "at least late 2014" is at least six years.  A major difference between the two situations is that Japan has experienced deflation and the United States has clearly not done so: in the four years between December 2008 and December 2009, total consumer prices climbed 1.8% per annum, and core CPI went up 1.2% per annum.  One should not overstate this difference, however.  For one thing, Japan’s deflation has been mildly throughout, not resembling the rapid drop of prices during the Great Depression and often coinciding with periods of expanding real economic activity.  More importantly, the need for persistent exceptionally low interest rates hinges not on the performance of prices but on whether real economies can tolerate tightening monetary policy.  In Japan, efforts to normalize monetary policy in 2000 and after 2006 were met by recessions. 

In the United States, the Fed had cut the fed funds target from 6.5% in late 2000 to 1.0% in June 2003 where such remained until mid-2004.  The Greenspan Fed thought it was acting very cautiously by stretching out the rate normalization process for two years, moving in predictable and consistent 25-basis point increments at 17 straight meetings until the funds rate was back to 5.25%.  Alas, the U.S. economy couldn’t handle even that light but firm application of lessening stimulus between mid-2004 and mid-2006.  The housing market crumbled, and the rest of the U.S. economy followed.  So did many other economies around the world.  With the level of U.S. employment about 30 million below its trendline from 1980-1999, it will be much later than late 2014 before the Fed is tightening against the backdrop of a fully employed labor market.

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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