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Business News/ Opinion / Online-views/  Zero interest rate, finally
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Zero interest rate, finally

Zero interest rate, finally

Illustration: Jayachandran / MintPremium

Illustration: Jayachandran / Mint

For the first time ever, the US has adopted a policy of zero interest rates. Tuesday’s meeting of the US Federal Open Markets Committee was thus a historic occasion, with the central bank announcing that it would establish a target range for the Fed funds rate between 0% and 0.25%. Japan is the only nation to have experimented with such a policy.

Illustration: Jayachandran / Mint

In any case, the Fed is fully aware of the limitations of monetary policy in the present extraordinary environment, as its chairman, Ben Bernanke, made amply clear in a speech delivered on 1 December. The problem is that while the central bank may reduce interest rates, that is no guarantee that banks will lend. Risk aversion is very high. Credit spreads continue to be elevated in spite of substantial monetary easing.

The US Fed knows the problem, which is why it has also announced several measures to fix it. The first of them is to signal to the banks that the very low Fed funds target rate will continue for some time. The second is to reduce the interest rate that the Fed pays on reserves that banks keep with it, thus forcing them to lend more. Other measures include buying mortgage-backed debt and buying securities backed by new consumer and small business loans, programmes that had already been announced earlier. The objective of these measures is to stabilize the housing market and address problems in credit card and small business loans. And the Fed has also promised “to consider ways of using its balance sheet to further support credit markets and economic activity", implying that it has more such unconventional weapons in its armoury. Simply put, the US Fed is now trying to bring down interest rates throughout the system directly, since the banking transmission mechanism has been damaged.

Will this new policy work? It has started to have an impact, as seen in lower mortgage rates as well as in the easing of conditions in the commercial paper market once the Fed decided to buy commercial paper directly. But it is not enough merely to ensure that the demand for funds will be met—it will also have to be complemented by a very sizeable fiscal stimulus that will directly inject demand into the economy.

Will the US Federal Reserve’s new policy work? Tell us at views@livemint.com

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Published: 17 Dec 2008, 11:17 PM IST
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