Catching up on the economic meltdown: (1) The Fed drops its funds rate to zero

"I'm sure there have been more incompetent, impotent and worthless central bankers than [Fed Chairman Ben] Bernanke, but he's swiftly ascending the ranks of the pantheon."

-- Ian Welsh, writing about the Fed dropping its funds rate to zero

Obviously I'm not an economist, so I try to listen to people whose track record suggests they know what they're talking about. Now, Paul Krugman has written enough about the experience in Japan when even dropping interest rates to zero didn't jog the economy for years and years, kind of suggesting that the same thing could happen here, that it was hard not to keep it mind as the Fed kept dropping its funds rate. This week, finally, it reached near-zero and even zero -- meaning that to those who borrow at that rate, the money is free.

I haven't seen anything more to the point than Ian Welsh's take from Tuesday on FireDogLake:

Fed Fires Its Last Shot of Monetary Policy
By Ian Welsh Tuesday December 16, 2008 3:05 pm

So, the Fed funds rate is down to zero (which doesn't mean most anyone can borrow at zero, the rate for banks is actually .5%, for example). There's a bit of room left to go, since the rate isn't actually zero, but essentially, the Fed has run out of ability to use standard monetary policy. It's broken and it doesn't work anymore. Deflationary expectations have set in, and folks figure that a dollar a year from now will be worth more than dollar now, so even borrowing at zero or .5% doesn't seem like that good a deal.

As Bloomberg pointed out [in the above-linked piece], the Bank of Japan kept rates at zero for five years, and it did squat. So the Fed has announced that it will use non-standard measures like buying up government backed housing bonds, and is considering buying long term treasuries, whose rates simply aren't dropping, even as people accept negative returns to buy short term securities. (They are doing so because the Fed was paying 1% interest on reserves, and treasuries can be used as reserves, which is why the Fed dropped the amount they pay on reserves to .25%.)

I'm going to state that the Fed isn't going to get a lot of bang for its hot-off-the-presses bucks for this. The banks aren't going to start lending to consumers, they are going to keep hoarding the money to fill up their losses (which are larger than all the money in the world, probably) and to use to buy up competitors who fail, cheap, for cents on the dollar.

I'm sure regular readers are sick of me saying this, but if the Feds want consumers to get credit at rates close to what the Federal Reserve sets, there are only two ways it's going to happen. The FDIC can take over banks that aren't lending money, and use them to lend direct to consumers, or the Fed can start lending to consumers directly.

William Poole may be right [again in the above-linked piece] that the Fed has just said it'll keep printing unlimited money till it fixes the economy, but unless the Fed does something to get that money into the hands of people who will actually spend it, the Fed can print a hell of a lot of money and have very little effect on the real economy. I may say I'm going to dig a hole till I get to China, and mean it, but just because I'm determined doesn't mean I'm going to be having that Chinese vacation any time soon.

Deflation can always be fixed, in the worst case scenario, the government could just send everyone a gift card for $50,000 which expires in 3 months and tell them to use it or lose it. But it can't be fixed by giving money to banks who won't lend it to the real economy, and even pushing down long bond rates really isn't going to matter as long as there are deflationary expectations.

So, expect the Fed to spend a LOT of money and get very little in return until someone uses some of the money to buy a clue. In the meantime, remember, you're probably going to have to pay this money back, no matter how little it does, unless the government manages to make itself go bankrupt. In theory the US need never go bankrupt, but a lot more of this, and it may turn out to be the lesser evil.

I'm sure there have been more incompetent, impotent and worthless central bankers than Bernanke, but he's swiftly ascending the ranks of the pantheon.

[Next: David Sirota suggests what to do.]

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