(Almost) ZIRP, will it work?

The US Federal Reserve has cut its benchmark interest rate to between 0% and 0.25% in an effort to boost credit growth and to deter deflation.

This(almost) zero interest rate policy is complimented by another Fed policy known as quantitative easing, by which it intends to create as much money as is needed to revive the economy. It may well succeed in reducing the risk of a sustained period of deflation, but if banks refuse to lend and instead focus on rebuilding their balance sheets, credit will remain scarce in the household and corporate sectors.

ZIRP and quantitative easing

The Fed has reduced its target overnight funds rate from 1% to a range of 0%-0.25%. When interest rates are at zero we will have a zero interest rate policy, or ZIRP. It is significant because interest rates can not fall further. By making money free (or almost free) to banks the Fed is hoping that it will be lent on into the broader economy and so stimulate growth.

The Fed has also announced that it will create as much money as is necessary to revive credit markets and bring life back to the world's largest economy, primarily through buying government bonds to ensure yields remain low and so the price of commercial credit will be low. The term used to describe this process is quantitative easing.

What is the Fed trying to achieve?

The Fed's actions are directed to two interconnected goals: avoiding deflation and stimulating the economy.

Inflation in the OECD is falling sharply, the danger is that against a background of weak consumer demand and rising unemployment we enter a period of deflation. This will make a recovery even harder, since deflation deters credit growth (as debts become progressively more expensive in real terms) and consumption (as goods will be cheaper in the future).

Fortunately, because the dollar is not linked to anything (i.e, gold) and can be printed at will, the Fed can create as many dollars as it wants. It should be able to avoid deflation simply by rolling the printing presses. Indeed, the Fed's balance sheet has grown from USD900 billion in September to more than USD2 trillion, and is likely to reach about USD3 trillion once its plan to buy mortgage backed debt and consumer debt is completed.

Our investment bank is forecasting a mild bout of deflation for the US economy in the first half of 2009, with headline inflation at -0.6% year on year in the second quarter before inflation returns later in the year.

As for stimulating the economy, so far banks have not used the cash to lend on, preferring instead they are rebuilding their balance sheets and harbour cash reserves. Conditions in the credit markets remain tight, creating cash flow problems for otherwise sound companies. A vicious circle is in place, by which restrictive lending by banks increases the risk of corporate default, leading to a further tightening of lending conditions. The cost of credit is not the issue, it is the availability.

There is a risk that the combination of the substantial monetary easing that we are seeing in the US, together with the fiscal spending boom promised by President-elect Obama, stokes a renewed bout of inflation.

The experience of Japan provides little guidance

Central banks and governments in the US and Europe have reacted much faster to the impact of the credit crunch than the Japanese authorities did after the asset bubble burst in 1990. Quantitative easing was introduced in 2001, while the problem of bad debt in banks' balance sheets was only really addressed from 2002 with a wave of mergers and write offs. But ultimately, perhaps, comparisons with Japan are difficult because Japan has a shrinking population (the number of 20-60 year olds, who make up the majority of active consumers, has been falling since 1994). A shrinking population is inherently a deflationary force in an economy. The population of the US is in contrast growing by around 1% a year. So it is difficult to compare the experiences of Japan with the current situation in the US.