Can U.S. interest rates effectively fall below zero?
Economists and traders expect the Federal Reserve to signal just that today when it makes its first policy announcement since lowering its benchmark target to between zero and 0.25 per cent, a move that left it no room to cut interest rates the conventional way.
Now, there are signs the central bank is about to become much more aggressive in its unorthodox efforts to drive rates effectively below zero.
The Fed has already been intervening in the debt market - or at least promising to do so - as part of its effort to bring down long-term rates. But economists expect even more of the kinds of measures known as quantitative easing as the Fed works to get the lending wheels turning again in the U.S. economy.
The central bank's target rate cannot actually fall below zero. So its measures are aimed at bringing long-term rates to where they would be if short-term rates could go negative, given the traditional spread between the two.
The easing measures will be aimed at forcing market interest rates even lower, which would in turn result in lower rates on everything from mortgages to corporate bonds.
The Fed has hinted in a leaked study that negative rates, while almost unprecedented, may be necessary given the depths of the recession.
"I think they're going to announce another [bond] buying spree," said Rich Yamarone, chief economist at Argus Research in New York. He forecasts that the central bank may spend another $100-billion (U.S.) on Treasuries and $150-billion on other debt.
Economists and investors are also on the lookout for comforting words from the Fed that the central bank has not lost sight of the possibility that throwing around so much money could spark inflation.
"They're just trying to explain why what they're doing makes sense and is not inflationary," said veteran Wall Street economist Ed Yardeni, president of Yardeni Research in New York.
The Fed already has the go-ahead to buy $300-billion of government bonds, more than $1-trillion worth of mortgage-backed securities, and $200-billion of debt issued by the government-sponsored agencies Fannie Mae and Freddie Mac.
So far, it has moved slowly on this front, acquiring less than $70-billion of Treasuries; $60-billion of agency debt; and $381-billion of mortgage-backed securities.
"It seems as though they're trying to carry a big stick and not use it," Mr. Yardeni said.
But that may be about to change.
The Fed has the power to do a lot more. The internal study recently leaked to the media suggested the ideal target interest rate would be minus-5 per cent, based on the current levels of unemployment, inflation and output.
While many discredit that model, known as the Taylor Rule, after the economist who devised the formula, the fact the Fed is talking about it signals that the bank is looking to drive rates still lower.
"Usually where there's smoke there's fire, and they're chatting up the idea of negative interest rates," Mr. Yamarone said.
If the Taylor Rule says the key interest rate ought to be down to minus-5 per cent to revive the economy, "then the Fed's commitment to quantitative easing and expanding its balance sheet can be justified on that basis," Mr. Yardeni said.
"What amount of quantitative easing is equivalent to a minus-5-per-cent interest rate is the exercise they're playing here. It's kind of silly. Other than computer models, it doesn't really mean anything." he said.
The only weapon left in the Fed's arsenal is to ratchet up the purchase of debt securities to drive down yields.
According to internal Fed estimates, the $300-billion of Treasury purchases planned so far would reduce the yield on 10-year Treasury bonds by about 25 basis points.
That would ripple into lower rates on consumer and business loans such as mortgages, whose rates are based on those of long-term government bonds.
So just how much buying would it take to force rates down to a level consistent with what the economy needs? A whopping $3.3-trillion, some economists suggested.
The Bank of Canada will be watching carefully because it too is out of room to cut short-term rates.
The Canadian central bank last week said that it would deploy unconventional measures such as buying bonds if the economy worsens.
(BOYD ERMAN AND BRIAN MILNER, April 29, 2009)
