THE GLOBAL TREND TOWARD LOWER INTEREST RATES

Are central banks slashing their way to nothing? Countries have been busily cutting borrowing costs. But as rates plunge, a valuable tool of monetary policy loses potency

BRIAN MILNER bmilner@globeandmail.com December 4, 2008

The race to zero is on.

As central banks around the world slash interest rates in a bid to stave off the worst effects of the continuing credit crisis and the widening global recession, official interest rates may soon effectively be reduced to nothing in key economies.

Zero rates are so rare that few policy makers - including Federal Reserve chairman Ben Bernanke, who has long prepared for such a moment - can predict what effects they would have.

There is no evidence that such an important symbolic move would breathe life into the moribund credit markets and get banks to stop hoarding capital or worried businesses and consumers to start borrowing again.

Indeed, taking rates to the bottom could create other problems, some economists warn, although central banks still have heavier weapons in their arsenal to get economies moving again, which they are now deploying.

"Zero is almost a sign of complete and total failure," said veteran Wall Street economist Ed Yardeni of Yardeni Research.

"It is reminiscent of Japan, and Japan was not exactly a success story."

Japan, which was indeed the poster child of zero rates and a sickly economy in the 1990s, is still hovering today at 0.3 per cent after leaving its key rate unchanged this week.

Switzerland could be the first to the bottom after slicing its benchmark rate in half last month to 1 per cent and indicating more easing to come. But the United States is also well on its way.

U.S. monetary officials, as well as their counterparts in Britain and other countries where rates are still substantially higher, are now openly sketching zero interest rate scenarios.

A widely expected U.S. cut later this month would take the target for the key federal funds rate to 0.5 per cent from 1 per cent. The actual rate, at which banks borrow from each other overnight, is already at the 0.5-per-cent level, so one more 50-basis-point cut would do the job.

"For all intents and purposes, we’re at the zero bound," said Robert Brusca, chief economist with Fact and Opinion Economics in New York and a long-time analyst of U.S. monetary policy. "Let’s not argue about what a percentage point could do, since we’ve already given half of it away in terms of what the effective funds rate is."

The problem with zero is that it dashes market expectations, which are based not on existing rates but on their direction.

That’s a problem Mr. Bernanke knows well from his investigation of the Japanese experience. Mr. Bernanke studied Japan while a professor at Princeton University and later as a Federal Reserve governor.

"It’s not only what you do with interest rates, but what markets expect you’re going to do the next time," said Mr. Brusca, a former divisional research chief with the Federal Reserve Bank of New York. "The closer you get to zero, the more they realize that there are not many next times left. We’ve already eliminated that potential for stimulus." In fact, once nominal rates reach bottom, most people will base their lending and spending plans on the assumption the only direction rates can take is back up. So cutting all the way to the bottom might be counterproductive.

"It might be better not to cut them [from 1 per cent], so people think you can still cut them," Mr. Brusca suggested.

Meanwhile, though, the race to the bottom paves the way for much more drastic action, which could include direct intervention by a reluctant Fed.

The U.S. central bank has already been aggressively doing what it calls quantitative easing - as opposed to the plain-vanilla easing of interest rate cuts (and a gentler way of saying that it is printing money hand over fist) - since mid-September, after the Bush administration pushed Wall Street investment bank Lehman Brothers into bankruptcy, and credit markets seized up.

Simply put, it means pouring reserves into the financial system at a rate far in excess of what would be needed to maintain the target interest rate, which explains why the actual federal funds rate is well below the target. In the past three months, the monetary base has expanded at an annual rate of 771 per cent, according to the latest statistics. And there is much more pump-priming to come.

Mr. Bernanke has outlined plans to purchase asset-backed securities and raised the possibility of buying long-dated Treasury bonds and agency debt to bring down mortgage rates and interest rates at the long end of the bond curve.

That would be welcome news, because the biggest problem is not short-term rates but the wide credit spreads that are forcing corporations to pay too much for their debt, analysts say.

Some economists argue that Mr. Bernanke should go even further, for instance by buying up corporate bonds and offering to acquire only asset-backed paper collateralized by new loans, rather than old ones, in an effort to get cash flowing into the hands of businesses and consumers.

In recent years, lowering benchmark rates has typically been a useful piece in the economic recovery puzzle. But this time, the collapse in demand is so enormous and the problems in the credit markets so unprecedented that simply dropping rates is not the answer.

"In a recession where they’re pushing on a string, it’s hard to be too concerned when they run out of string," Mr. Brusca said.

Nevertheless, the trend remains straight down. Bank of Canada watchers see the bank rate falling to at least 1.5 per cent by early 2009 and possibly lower. Faced with deeper economic problems, the European central banks will be even more aggressive.

Central bank watchers in Britain now expect the Bank of England to hack at least another percentage point off the official rate this week to 2 per cent. That matches the lowest level since the bank opened shop in 1694. The overnight index swap market has priced in an even deeper cut of 1.5 percentage points.

"I expect to see zero rates before long throughout the North Atlantic region," Willem Buiter, a former Bank of England official, said in a television interview this week.

*****

The banker’s tool kit

Monetary policy tools the U.S. central bank can use, aside from interest rates, to boost the economy

New lending

The Fed can use its cash (and has) to buy commercial paper, buy loans or inject money into other central banks.

Buy bonds

Purchasing long-term debt such as Treasury notes or corporate debt helps send down long-term interest rates.

Cash in the safe

The Fed requires banks to keep a certain ratio of cash in the vault versus customer deposits. Reducing this ratio would free up lending, but is rarely done.

Discount window

The Fed can trim the rate it charges to lend money directly to banks, known as the discount rate. This interest rate ranges from 1.25 per cent to 1.75 per cent.

U.S. Federal Reserve Board

*****

Britain: 3%

Switzerland: 1%

Japan: 0.3%

Canada: 2.25%

United States: 1%

European central bank: 3.25%

Australia: 4.25%