This Is What the End of the Line Looks Like

by: James Picerno

This is what the end of the line looks like; we're staring at the floor.

The Federal Reserve announced Tuesday afternoon that it was "establishing a target range for the federal funds rate of 0 to 1/4 percent." This is a bit like a fish issuing a press release that it will hereafter be swimming in water.

The target rate for Fed funds is lowered anew to just above zero, but the effective Fed funds (which is based on actual banking transactions) is already there, and has been for some time. Nonetheless, Bernanke and the boys are right to announce the new lower range for the target Fed funds, which works out to as much as a 75-basis-point cut from yesterday's target rate. Just don't hold your breath for an encore performance when the next FOMC meeting commences on January 28-29.

As is now crystal clear, the economy is weak and getting weaker and a similar sucking sound is abundantly clear in prices, as we noted earlier today. To a man with a hammer, the world looks like a nail. For the Fed, a general decline in prices and slumping economic conditions cry out for monetary stimulus. Today, the central bank was still able to satisfy. But from here on out it's time for plan B.

The new world order of unconventional monetary policy easing begins now. Yes, the Fed has been practicing the dark art of quantitative easing for some time. One example: using various levers to lower long-term rates, which is usually the province of market forces. On the surface, there appears to be some traction on this front. The 10-year Treasury yield, for instance, is quickly plunging toward the 2% mark. Just two months ago it was 4%. Of course, it's not clear if the fall in the 10-year is due primarily to Fed efforts or just the general fear of deflation and recession or a little of both. There are many questions in the new world order and few concrete answers.

Along those lines, it's generally unclear just how effective quantitative easing will be, in part because its track record is sketchy and the medicine has been rarely applied. The great deflation of Japan offers the most recent experiment in nontraditional monetary policy of magnitude. Alas, the jury's still out on whether it was a success, failure or something in between. Looking for clues about how to proceed from Japanese deflation is a bit like looking for consensus on the Internet: lots of information wrapped in a hurricane of debate.

Consider a 2006 essay by the San Francisco Fed:

"While there is little evidence that quantitative easing [in Japan] stimulated overall lending activity, there does appear to be some evidence that quantitative easing disproportionately supported the weakest Japanese banks." But there's no free lunch because "in strengthening the performance of the weakest Japanese banks, quantitative easing may have had the undesired impact of delaying structural reform."

"Some of these alternative policy tools are relatively unfamiliar," Russell Jones, global head of fixed-income research at RBC Capital Markets, told Reuters last month. "They may raise practical problems of implementation and calibration of their likely economic effects."

That doesn't mean we shouldn't embrace innovation at this juncture, but we shouldn't expect miracles either. The good news is that quantitative easing comes in many flavors, and so there's more than one way to skin this monetary cat. Imagination may count for much in these times. If something doesn't seem to work here, one can try an alternative effort over there. Good thing, too, since the marginal risk of experimenting at this point is virtually nil relative to the risks of letting economic weakness and deflationary tendencies build.

But it's hard to overemphasize the fact that we're now in a gray area of monetary policy, a type of never-never land that has little precedent in the modern era, at least in the U.S. Graham Turner of GFC Economics is correct when he warns that it's best to keep an open mind about the possible outcomes from here on out. In an October essay in FT's economists' forum he wrote, "There is no guarantee that such a radical monetary policy will succeed. Central banks may have left it too late. Cutting the Fed funds target to 0% is necessary, but is unlikely to suffice. Driving the 30-year Treasury yield down to Japanese style levels, of 1% or so, may not be enough either."

The key problem is that much of the current woes seem to have unfolded / accelerated in the wake of Lehman Brothers' collapse in September. Rarely, if ever, has such a large economy deteriorated so quickly and with such force and depth. That's made the challenge immensely more difficult. It was, after all, only a few months ago that oil was climbing to absurdly high records and inflation was still considered a real and present danger. But now we have the opposite threat. Six months sometimes makes all the difference in the world, even in the dismal science.

The world has changed — radically, and it may change radically yet again. Exactly what does or doesn't suffice for monetary policy in the weeks and months ahead remains an open debate. No doubt there'll be definitive answers after all this is over. The playbook for monetary policy may be rewritten as a result. But for the immediate future, it's anyone's guess what happens (or should happen) next. No doubt we'll hear lots of policy recommendations from far and near. Making sense of it all, if at all, may be the toughest challenge.