ZIRP at the Fed

Financial Express, 22 December 2008

The US Fed had dropped interest rates to roughly 0. The real importance of the recent announcements are two-fold. First, the Fed has announced that interest rates will stay near zero for a while. This will drive down interest rates for longer maturities. Second, the Fed has announced that it will directly buy non-traditional assets so as to drive down interest rates across the economy. The willingness of the US Fed to do unorthodox things to help bring the US economy back on its feet is good for the world economy.

ZIRP is a word which will now become widely used. It stands for `Zero Interest Rate Policy', the strange zone where the short-term interest rate charged by a central bank goes to 0. However, when the US Fed announced that the rate dropped to near zero, this was less momentous than it seems, because the bond market already had near-zero rates. When Lehman Brothers died, there was a `flight to quality' and massive capital flows into America. On 17 September, the interest rate on 90-day US treasury bills dropped to 0.03%. Interest rates have stayed low ever since. From 25th November onwards, the 90-day treasury bill in America has been below 0.1% every day. So a policy rate of near zero is just catching up with what the market has been doing.

The real story going on in America is more complicated. Under normal conditions, the central bank only controls the interest rate for short dated riskless borrowing. All other rates are determined by the market, based on expectations about how the central bank will respond to news at future dates. The Bond-Currency-Derivatives (BCD) Nexus plays out the impact of a change in the policy rate into changes in interest rates for all maturities and all credit qualities. The BCD Nexus does the heavy lifting of going out and influencing the economy, based on small hints from the central bank. It delivers the "monetary policy transmission": the process through which the actions of the central bank influence the economy.

This arrangement has two advantages. First, the job of the central bank is made easier: demand conditions in the economy are modifed by merely making millimetric changes to the short-term interest rate. Second, it makes sense for the central bank to avoid trading in any other assets in the economy. The free market knows more about how to price assets than the central bank. How is the central bank to know what is the correct price of a currency or a 10 year bond? It is best for the government to stay out of all asset markets, other than one (the very short end of the money market).

With the difficulties in the US financial system, the BCD Nexus has broken down. There is a flight to quality and too many financial firms are only feeling safe holding government bonds. Long-term bonds and particularly corporate bonds are languishing at high interest rates. Even though the policy rate has dropped, the monetary policy transmission has been malfunctioning so that other interest rates in the economy have not responded. It is amusing to recall that while the US requires a large financial crisis to achieve a malfunctioning BCD Nexus and hence a broken monetary policy transmission, we in India have this abnormal situation every day, owing to decades of effort by policy makers at preventing the BCD Nexus from coming about.

How does the US Fed respond to this problem? Bernanke and his colleagues have rightly argued that when the BCD Nexus malfunctions, the Fed cannot accept this lying down. They are doing two things about it.

First, their recent statement said: "the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time." They have not just cut the policy rate to near zero: they have promised to keep it low for a while. This helps set off the arbitrage process of the bond market though which low interest rates creep from the very short term to longer maturities of bonds.

Second, the Fed has promised to buy mortgage-related securities and possibly long-dated government bonds, so as to push down long-term borrowing costs. This violates the normal principle that market prices of assets should not be distorted by governments. But these are unusual times and they require suspending the principles that are sound in normal times.

The unusual behaviour of the Fed has bloated its balance sheet from $900 billion to $2 trillion and this could grow further. When finance worked well, the Fed had a simple task of controlling the short term interest rate and leaving the rest to finance. But finance has broken down. Hence, the Fed is reaching out to the economy by going over the heads of the financiers. Once the BCD Nexus starts working properly again, the Fed will unwind all the extraordinary things that were done in this period.

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