Get To Dah Choppah!

Roubini vs. Helicopter Ben's Zero Interest Rate Policy (ZIRP)!

Round One.

Fight!

The Fed decision to cut the target for the Fed Funds rate to the 0% to 0.25% range is just underwriting what was already obvious and happening in reality: While the target Fed Funds was until Tuesday still 1%, in the last few weeks--following the massive increase in liquidity by the Fed--the actual Fed Funds was already trading at a level literally close to 0%.

So the Fed just formalized what had already been happening for weeks now, i.e., that the Fed Funds rate was already zero and that the Fed had already moved to quantitative and qualitative easing (QE) in the form of a massive increase in the monetary base and aggressive use of monetary policy to reduce short-term and long-term market rates that are stubbornly high in a sign that the credit crunch is severe and worsening.

I predicted early in 2008 that the Fed Funds rate "would be closer to 0% than to 1%" in the midst of a severe recession. Now, 12 months into this severe recession--a recession that will last at least another 12 months (if not, as is possible, much longer)--the Fed Funds rate is already down to 0% (the beginning of the zero-interest-rate-policy, or ZIRP, for the U.S.) and the Fed has moved into uncharted unorthodox monetary policy as a severe stag-deflation is taking place.

And, as predicted by me over a month ago, the Fed is now committed to keep the Fed Funds rate close to zero for a long time (as a way to push lower long term Treasury yields); purchasing agency debt and agency MBS in massive amounts; and even considering purchasing long-term Treasuries as a way to push lower long-term government bond yields that are already falling sharply.

More aggressive policy actions may be undertaken by the Fed as a severe credit crunch shows no signs of relenting. In a 2002 speech on deflation, Ben Bernanke spoke even of helicopter drops of money, monetizing fiscal deficits and even buying equities.

The latter actions have already been partially undertaken: The Fed is effectively already monetizing U.S. fiscal deficits as the purchase of markets assets is financed with the Fed printing presses rather than the TARP program. And now, with the Fed considering the purchase of long-term Treasuries, such monetization of deficits will be made more formal.

Also, since the TARP has been turned into a program to recapitalize financial institutions (and thus boost their capital and market value), the U.S. has already effectively intervened indirectly in the equity market (by partially nationalizing a good part of the financial system). Once the Fed starts to buy the long-term Treasuries financing the TARP program, this indirect Fed purchase of U.S. equities will be even clearer.

While Fed actions to reduce mortgage rates--via purchases of agency debt and agency MBS--are partially successful as long-term mortgage rates are falling, most of the Fed purchases of private assets have been so far limited to very high-grade securities.

Thus, the gap between the yield on high-grade commercial paper purchased by the Fed and the one that the Fed is not purchasing is sharply rising; ditto for the gap between agency MBS and private label MBS. Also, while long-term Treasury yields are sharply falling, the spread of corporate bonds--both high-yield and high-grade--relative to Treasuries remains huge as a sign of a severe credit crunch.

Thus, as a next step, the Fed may be soon forced to walk down the credit curve and start buying private short-term and long-term securities with lower credit ratings. That would mean the Fed will take on even more credit risk than it is already taking on today while purchasing illiquid private assets. But desperate times lead to desperate actions by desperate policy makers.

Not good. In other words, the Fed plan is this:

1. Lower interest rates to zero.
   
2. Make shit up as we go along and hope it works.
   
3. Profit!

Which is a friggin' great plan, if, you know, you're not the central bank of the largest economy on Earth.

We're currently on Step 2 up there. We'll be there for quite some time.