Across the Curve

JPMorgan Predicts Zero Funds Target

JPMorgan economists are predicting that the Fed will reduce rated by 50 basis points at each of the next two meetings. That would bring the target to zero. Here is the note from JPM:

We now look for a 50bp cut in the target fed funds rate at the December 16 meeting, followed by an additional 50bp cut at the January 28 meeting.  We believe the Fed then continues to conduct a zero-interest rate policy (ZIRP) for the remainder of 2009.  The change in our call is motivated in large part by the risk that deflation becomes more likely in an environment where labor market slack is building, and ongoing financial tightening is delaying the prospect that slack begins to get worked down.

Taking the target rate to 0% would not be costless for the Fed.  One concern that has been voiced in the past relates to the effect on money market mutual funds.  We do not think this cost is enough to constrain the Fed, in part because facilities such as the Money Market Investor Funding Facility (MMIFF) should help to provide a more orderly transition for this market.  Another cost that has been mentioned is the loss of public confidence if there is a perception that the Fed has “run out of ammo.”  We don’t believe going to ZIRP implies that the Fed cannot do more, and we would expect the Fed’s leadership to communicate that even a central bank operating at ZIRP still has many tools at its disposal.  

Along these lines it becomes natural to ask if quantitative easing (QE) follows ZIRP.  While there is no standard accepted definition of QE, an increasing number of Fed speakers have expressed the view that the recent increase in the Fed’s balance sheet constitutes QE, a view we share.  Normally, one would expect ZIRP to precede QE, but because of the flexibility created by interest on reserves, in the current case QE can actually precede ZIRP.  While QE has been ongoing for the past two months, it could potentially turn more aggressive by monetizing fiscal stimulus or buying GSE obligations. Before ramping up QE, the path of least resistance may be for the Fed to first communicate to the markets that the nature of the current economic woes should keep rates low for an extended period.