Here Come the ZIRP

As a former central banker, I cannot hold the pleasure of a short comment on the so-called ZIRP.

Yes, indeed the Fed has gone as far as ZIRP (Zero Interest Rate Policy). It has also committed to QE (Quantitative Easing) by inflating its balance sheet to jump-start the bankrupt US economy.

There are three questions that we can ask ourselves regarding the ZIRP/QE policy. I will try to bring my own answer to each question.

1. Did the Fed have another choice?

No. Because once you committed to QE - which was arguably the case for the Fed, at least since the Lehman (LEHMQ.PK) collapse - you are supposed to use every possible means to achieve that, including ZIRP.

2. Could it work?

"It depends." Actually, despite a substantial body of literature on ZIRP/QE and dozens of academic studies reviewing the Japanese experience, there is no evidence that QE works. It is a pure monetary - let's even say monetarist - bet. However, as we know, since New Keynesian Economics became the mainstream of short term macroeconomic analysis, it "could work" precisely because it is based on an illusion, if it can produce an artificially generated price increase that lifts supply and demand by avoiding deflation.

3. When will it produce any effects?

Here comes the main issue. As Krugman and other economists pointed out, it can take years before ZIRP/QE produce their effects. It depends on the ability of the banking system to channel the extra liquidity to the economy. By all accounts, in 2009, US banks will use the money to restructure their balance sheets and drop the remaining toxic waste they still hold rather than coming back aggressively on the credit front. It could take as long as three years to revive the bankers' animal spirits from fear to greed.

To avoid these long delays, what is needed is a combination of ZIRP/QE with strong demand stimulation in the form of a massive fiscal package and a low real effective exchange rate. Ironically, deflation could be useful for the latter, but it would definitively annihilate the effects of the former.

Bottom Line

Was ZIRP necessary? Yes, it was.

Will ZIRP work and when? Nothing is certain, but it could take a very long time.

Will ZIRP alone work? Clearly not.

Comments

[socrateazz:]

Is NIRP possible? Paying folk to borrow money! If ZIRP is OK, No reason a negative interest rate policy could not be implemented for the same purpose. People will not put their wealth in banks then. But the goal would be to get money into peoples hands ...Right. I wonder!

2008 Dec 18 07:26 AM

[investor88:]

So we may bump around trading ranges for a number of years rather than any V shape recovery. It will be a trader's market.

2008 Dec 18 08:05 AM

[D. McHattie:]

Well, we know that the Obama administration has the support of Congress in passing a massive fiscal stimulus package, right? Not judging anyone but that's what democrats do: they spend money. In fact, they're good at it.

Sure, there will be a metric tonne of waste and I'm sure the usual suspects will line up at the trough for their ration of pork. But the fiat currency will enter the system and it will get spent.

It seems to me, in light of this, we shouldn't be waiting years for a resumption of inflation.

2008 Dec 18 10:01 AM

[digitaldorobo:]

"that's what democrats do: they spend money. In fact,
> they're good at it."

Drop your knee-jerk republicansim.

Take a look at the massive spending during Reagan, Bush Sr., and Bush Jr's terms. They outspent the Democrats by far and put the US in deep debt.

Stop blaming Democrats or anyone else.




On Dec 18 10:01 AM D. McHattie wrote:

> Well, we know that the Obama administration has the support of Congress
> in passing a massive fiscal stimulus package, right? Not judging
> anyone but that's what democrats do: they spend money. In fact,
> they're good at it.
>
> Sure, there will be a metric tonne of waste and I'm sure the usual
> suspects will line up at the trough for their ration of pork. But
> the fiat currency will enter the system and it will get spent.<br/>
>
> It seems to me, in light of this, we shouldn't be waiting years for
> a resumption of inflation.

2008 Dec 18 10:22 AM

[vaughn:]

ZIRP and QE (printing money) only help banks to screw up savers. For anyone else who can borrow money from banks, they still need to pay interest. If the expected income is not enough to pay for the interest and profit, no one will borrow even if banks are willing to lend.

Bottom line: unless excessive debt is purged from the system, ZIRP/QE will only buy up more time to avoid the default of debts, keeping banks alive via zero rate loan from the FED.

2008 Dec 18 06:28 PM