The Debate About Zero

Just a few short months ago, it was unthinkable. A year ago, it was beyond the pale. But the extraordinary arrived yesterday when the 10-year Treasury yield fell to lows previously unseen.

The 10-year closed on Tuesday at 2.69%, a record low. The embedded message is clear: The market expects deflation, or something close to it. In the rush to find a safe haven, investors are bidding up the prices of government bonds to extreme levels. In turn, yields are falling to depths few thought possible.

The primary source of this outlook is, of course, the weak economy. "The big picture background for these very, very low Treasury rates is the weakest economy we've seen in at least a generation," Jay Mueller, senior portfolio manager at Wells Capital Management, tells BusinessWeek. "We're looking at a severe recession and the Treasury markets are reflecting that kind of an outlook."

The favored policy response for deflation is cheap money, and the Federal Reserve is moving heaven and earth to engineer just that. Indeed, the effective Fed fund rate is roughly 0.5%. But that invites the challenges that come with the so-called zero bound.

Make no mistake: We are increasingly in uncharted territory. The limited history of fighting deflation, real or perceived, ensures passage into the unknown as rates approach zero. Adding to the confusion: Some influential inflation hawks are warning that deflation isn't a clear and present danger.

St. Louis Fed President James Bullard yesterday said that further rate cuts elevate the risk of stoking deflation in the U.S. That runs counter to the widely held view that lower interest rates are a key weapon in keeping deflation at bay. Nonetheless, he's warning of the opposite, as per this report from Bloomberg News:

“I’m more concerned at these very low levels about the Japanese outcome last decade," Bullard said today in an interview, while noting that deflation isn’t an immediate threat. Japan’s central bank “went to zero” with its main interest rate, and “deflation becomes a self-fulfilling thing and you are stuck at zero.” ... “I have not been a fan of going to really low levels,” Bullard said in an earlier Bloomberg Television interview. “Why is it zero this time? I don’t quite get that, though I know some people want to go in that direction.” ... “There are limits of what you can do with interest rate policy,” he said. “We have a market conditioned to think of interest rates as the definition of monetary policy.”

Meanwhile, Philadelphia Federal Bank Reserve President Charles Plosser questions the idea that deflation is a risk. As he explains in a recent speech reported via Reuters, falling prices of late have "prompted some commentators to suggest that the U.S. is facing a threat of sustained deflation, as we did in the Great Depression or as Japan faced for a decade. I do not believe this is a serious threat."

The bond market thinks otherwise. The January '09 Fed funds futures contract is now priced in anticipation of a 50-basis-point rate cut, which would bring the target Fed funds down to 0.5%.

Additional rate cuts at this point may or may not be productive, depending on who's talking. But for good or ill, there's not a lot of mystery these days about where monetary policy is headed.

Comments

[Jason Rines...:]

I like the Dallas Fed, Fischer. He has been far more accurate in his predictions over the last year. In fact, I also like the Texas conservative Republicans, the food, the culture, the women. How about we move the capitol of the U.S. to Dallas and start over with our government?

2008 Dec 03 12:27 PM

[Chris B:]

Interest rates for overnight loans are not the only weapon we have against deflation. They are the fine-tuning tool. The treasury can print as much cash as it wants and show up to the t-bond auctions and buy everything in sight at whatever price it takes, flooding the market with capital. Then there's fiscal stimulus. This year's "stimulus" checks are just the first of many. These are the heavy equipment tools.

When "helicopter" Ben fires up the printing presses, I doubt you want to be in 2.7% treasury bonds. Get ready for a wild ride, as the market suddenly realizes that they underestimated the ability of government to inflate.

2008 Dec 03 01:00 PM

[SW Richmond:]

I agree, and for one major reason: whether it works or not, the Fed and Treasury are totally committed to reflation. The only things that can stop them are success, currency collapse, or overt threats from powerful foreign debt holders.


On Dec 03 01:00 PM Chris B wrote:

> Interest rates for overnight loans are not the only weapon we have
> against deflation. They are the fine-tuning tool. The treasury
> can print as much cash as it wants and show up to the t-bond auctions
> and buy everything in sight at whatever price it takes, flooding
> the market with capital. Then there's fiscal stimulus. This year's
> "stimulus" checks are just the first of many. These are the heavy
> equipment tools.
>
> When "helicopter" Ben fires up the printing presses, I doubt you
> want to be in 2.7% treasury bonds. Get ready for a wild ride, as
> the market suddenly realizes that they underestimated the ability
> of government to inflate.

2008 Dec 03 02:03 PM

[Roger Knights:]

This site needs to rename its "Report abuse" button to "Report abuse or double-post"!

2008 Dec 03 02:39 PM

[SW Richmond:]

Roger,

Using FIrefox...I clicked on "submit" once, and firefox froze. I let it run a minute to see if it would resolve. It didn't, so I closed firefox. Apologies everywhere they are due. This was not a deliberate act.


On Dec 03 02:39 PM Roger Knights wrote:

> This site needs to rename its "Report abuse" button to "Report abuse
> or double-post"!

2008 Dec 03 03:26 PM

[dixie:]

This is GOOD NEWS. The recession would end if 30 year mortgage rates dropped to 4% or less.
Consumers would have money to spend elsewhere, foreclosures would diminish, and home sales and all construction would take off.

2008 Dec 03 04:01 PM

[jepittman:]

It never ceases to amaze me how quick people are to use buzz words such as 'uncharted waters', 'perfect storm', etc.,etc., There is a precedent for these actions by the Federal Reserve. During World War ll the Fed brought short term rates to nearly zero and engaged in 'quantitative easing' by bidding treasury bonds to a target yield. This is largly how the war was financed. We turned out just fine by the way.

2008 Dec 03 04:20 PM

[Chris B:]

Dixie,
Bill Gross says 30 year mortgage rates could fall to 4.5%. I guess the government would be the only lender. Given recent history, I'm sure that any company that owns mortgages wishes they owned less.

www.cnbc.com/id/280316...


On Dec 03 04:01 PM dixie wrote:

> This is GOOD NEWS. The recession would end if 30 year mortgage rates
> dropped to 4% or less.
> Consumers would have money to spend elsewhere, foreclosures would
> diminish, and home sales and all construction would take off. <br/>

2008 Dec 03 05:21 PM

[Moon Kil Woong:]

The Fed and Treaasury discussion of forcing mortgage rates to 4.5% only stalls anyone from buying now at 5.5-6%. What then? Why buy at 4.5% when rates may go to 0 and I can get a loan at 4% or 3.5%. Does the Fed and the Treasury know anything about economic theory? Their actions to stimulate are only making everything worse.

Why should banks clean up their CDS and CDO liabilities when having them gets bailout $ and keeps them out of bankruptcy. Why disclose, look bad, get fired, and everyone blames you when you can just hoard money as BOA mentioned to pay your current visable liabilities and weather out the storm paying only the minimum cleaning up your off book garbage. Sure it takes 30 years. So what. Let the US economy and everyone rot. This is the same as the Japanese banks did. And what did their monetary policy do? The same as us. Let the banks hide their losses forever and write them off as the country nationalized, issues bonds, and uses public money to effectively socialize large swaths of the economy.

LOL getting anyone to buy anything with that mentality Bernake and Paulson. You can rain as much money as you want on banks. They aren't going to lend anytime soon and why borrow while you keep undermining the economy. You have destabilized everything.

2008 Dec 04 02:15 AM

[notsosmart:]

there seems to be one thing for sure-nobody knows anything.

2008 Dec 04 01:45 PM