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Zero interest… for years

Scott Jagow May 26, 2009

Those Fed meetings we used to watch so closely because of interest rate decisions may be pretty uneventful for a long time. A top Federal Reserve economist says the Fed will probably need to keep its key interest rate near zero, not for months, but for years.

Glenn Rudebusch, the senior vice president at the San Francisco Fed, had this analysis in an economic letter released today:

According to the historical policy rule and FOMC economic forecasts, the funds rate should be near its zero lower bound not just for the next six or nine months, but for several years. The policy shortfall persists even though the economy is expected to start to grow later this year. Given the severe depth of the current recession, it will require several years of strong economic growth before most of the slack in the economy is eliminated and the recommended funds rate turns positive.

In fact, Rudebusch says the Fed Funds Rate would need to be minus 5% by the end of this year for the Fed to deliver monetary stimulus consistent with its past behavior. The Fed has no plans for a negative interest rate. Since December, the target rate has been between zero and .25%.

But to all the inflation worriers out there, Rudebusch says the Fed is nimble:

“…the Fed’s short-term loans can be unwound quickly, and its portfolio of securities can be readily sold into the open market, so there should be ample time to normalize monetary policy when needed.”

It would be needed if inflation rears its head. And that could happen if all the money that’s been
fed (or should I say Fed?) into the financial system actually makes its way into circulation. But if you feel like wonking out, here’s a take on why inflation is no threat whatsoever. In a nutshell:

Keep in mind the most fundamental definition of inflation: Too much money chasing too few goods. Now consider that the collective household balance sheet of America has shrunk over the last six quarters by some $13 trillion dollars… Ongoing changes in spending habits and attitudes toward credit itself are going to be secular — not cyclical — in nature. These are deflationary, not inflationary, changes.

In other words, Americans have battened down the spending hatches for the long haul. Of course, if people are saving, according to the Fed’s interest rate prediction, they’ll be getting miniscule interest on that money for years to come.

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