Why interest rates are headed to 0%
Posted
Oct 31 2008, 04:56 AM
by
Anthony Mirhaydari
Rating:
Get ready for 0% interest rates. Here's why.
This week the Fed cut its target overnight interest rate to just 1% from 1.5%, but that won't end the problems our economy faces. Interest rates have returned to levels that started the epic final leg of the housing bubble in 2003 under Greenspan's watch. Before that, money hadn't been as cheap since the 1950s.
The problem is that the global economy's inflationary fever is quickly turning into a cold, deflationary sweat. In the words of my favorite Wall Street economist, David Rosenberg of Merrill Lynch, "deflationary forces are already in motion and look irreversible."
Deflation would be destructive: it makes debt harder to pay back, reduces demand, and leads to higher unemployment. What's worse, deflation is self-reinforcing. Faced with the dire consequences of inaction, the Fed will have no choice but to lower rates to historic levels.
This intention was telegraphed in yesterday's official statement, in which the Fed noted that it "expects inflation to moderate" and that "downside risks to growth remain." At its September meeting, the Fed said the inflation outlook was "highly uncertain." A lot has changed over the last six weeks.
Stocks and commodities have yet to definitively bottom, layoffs are increasing dramatically, and the consumer is buckling in a big way under unprecedented pressure. Beneath Thursday's terrible GDP figures, we learned that overall consumer spending had its biggest decline since 1980. Spending on non-durable goods like food and clothes was off 6.4% -- the worst reading since 1950.
In comparison, with the cut to 1% back in 2003, the Fed signaled it was done. The recession had been over for 18 months, the commodity bonanza had already begun, and the stock market had bottomed seven months earlier.
So this downward leg isn't over yet. As I discussed in my last blog post, it doesn't look like the economic storm will end until June at the earliest. With inflation currently near 5%, Rosenberg believes the year-over-year inflation measure could move into "slight negative terrain" by the middle of next year -- something not seen in the United States since 1948-1949 and 1954-1955.
Now, for the really scary part: Cutting overnight interest rates to near 0% may still not do the trick. The problem relates to still high interbank lending rates, household deleveraging, and what economists call the "velocity of money."
Money velocity refers to how much work a single dollar can do in the economy -- how many hands it can touch. More consumer credit means that a dollar can do more work. More interbank lending means that a dollar can do more work. When velocity slows, as it is now, it effectively shrinks the number of dollars working through the economy. This is part of the reason interest rates on credit cards and mortgages remain high.
Thankfully, Fed chairman Ben Bernanke is an expert in the surprisingly simple solution to this complex problem: Print, spend, and lend lots and lots of money. The Federal Reserve, in just the last 13 weeks, has expanded its balance sheet at a 1,640% annual rate, to $18 trillion. Relative to GDP, it's still only half the size reached by the Bank of Japan during its fight against deflation.
Disclosure: I don’t own or control shares in any of the companies mentioned. I can be contacted at anthony.mirhaydari@live.com
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