Here Comes Rock Bottom

When the Federal Reserve Bank's board of governors meets starting tomorrow, they will discuss what to do to stanch America's months-long financial hemorrhage. Since the federal funds rate, their primary policy tool, is sitting at one percent, come the end of next month they may need to find another way to try to ease credit. Analysts are predicting a half-point drop when this week's meeting ends Tuesday. That would put us within an lolcat's length of the Zero Lower Bound, which is what economists call the minimum possible nominal interest rate.

There's nothing the Fed could do to set nominal interest rates below zero. Once they've set the rate that low, we're in what's called a liquidity trap and need to find some other way to stimulate the economy. The Fed's other two policy tools are the discount rate and the required reserve rate. The former is the rate at which banks borrow money from the Fed, usually kept somewhat higher than the Fed funds rate to encourage banks to borrow from each other before coming to the Fed. The discount rate is at 1.25 percent right now, which doesn't leave a prodigious amount of room for easing.

The required reserve ratio is the fraction of a bank's deposits which must remain in its vaults rather than being lent out. When a bank has financial obligations to meet, it draws from its reserves until they drop to the required minimum level and then borrows from other banks or the Fed. The lower the reserve requirement, the less money in vaults and the more circulating in the economy. Since all of these policies rely on banks to increase lending and thereby boost investment and consumer spending, I have to be skeptical of what monetary policy is going to achieve. U.S. banks have already been handed the better part of $700 billion, to little or no benefit.

I have a feeling that what Fed chief Ben Bernanke is going to end up doing is going to Capitol Hill and calling for a fiscal stimulus. In 2004, Bernanke published the definitive paper on the liquidity trap in Japan in the 1990s (it's an enlightening read, I can assure you). He and his colleagues concluded that the Bank of Japan was not vigorous enough in its attempts to overcome Japan's slumping economy, so that after a number of years, BOJ's policy options had been exhausted but the recession had not ended. The Fed has shown unprecedented aggression in combating the current recession, but conditions will likely continue to worsen even with nominal interest rates at zero.

Paul Krugman and Robert Reich have both been calling for a major stimulus package in the form of spending on infrastructure and aid to state and local governments. Krugman in particular has declared that "prudence is folly," that is, caution will only mean a deeper and longer recession. This is a good opportunity to do a long list of things we have been neglecting and will probably reduce future deficits. Really, what have we got to lose at this point?