As Rates Race to Zero, Printing Presses Gear Up
When the Federal Reserve policymakers decide on interest rates Tuesday, investors will probably look one step beyond their decision, to gauge how much money will the Fed be willing to print once it is out of rate ammunition.
Rates won't likely hit zero Tuesday, but this could be unavoidable in the near future, according to strategists and market experts.
Current DateTime: 06:35:54 18 Dec 2008
LinksList Documentid: 28193666
* The Fed May Surprise the Markets
* Retail Sales, Inflation Decline
* Charts: Dollar Fall May Begin
* Jobless Claims at 26-Year High
Unemployment is likely to surge after more job cuts have been announced by banks and the U.S. auto industry teetering on the brink of collapse. The housing market is likely to take another hit as more people lose their jobs, and consumption will plummet further.
"Rates will fall close to zero. Everywhere," Hugh Hendry, chief investment officer and partner, Eclectica, told CNBC.com. "The central banks will be forced to take them to zero because of the widespread disruption in society, for job losses."
And nations may have to let them stay there for a long time, while finding new ways of easing policy even further.
"It's a typical race to the bottom," Ronald Stoeferle, equities analyst, Erste Bank, told CNBC.com. "But it's probably too late for this. In the current situation, I think we have to wait for this whole drama to unfold."
The drama may be prolonged and could take its toll on one of the world's most successful currencies: the euro [EUR-TN 1.4287 0.0042 (+0.29%) ].
If this crisis happened 15 years ago, currencies of various countries in Europe would have depreciated and this would have mitigated some of the shock, Hendry said.
During the recent boom years, Europe was captured by private equity mania, small businesses were laden with debt, credit cards and consumer credit flourished. Now the debt must be paid and Hendry says it may take 10 years for this to be achieved.
A 10 percent to 15 percent contraction of the European economy is possible over the next 36 months and after that "we'll spend six years recouping to the GDP level of 2007," he predicted.
Without a flexible exchange rate, unemployment will surge, especially in the weaker euro zone members, the PIIGS as Hendry calls them – Portugal, Italy, Ireland, Greece and Spain – and these countries will break out of the single currency.
How Zero Rates Can Sting
The problem with massive easing is that once interest rates have hit zero there is nowhere they can go, analysts said. And rates at 0 percent can start to do damage.
Rates below 0.5 percent in the U.S. could generate losses at money market mutual funds, which charge a fixed management fee, Paul Ashworth, an analyst with Capital Economics, wrote in a research note.
In turn, outflows from these funds would have a knock-on effect on already battered credit markets, as money market funds have over $3 trillion under management and a third of that is invested in commercial paper and corporate bonds.
* Check Currencies Here
* Click Here for Credit Spreads
* Check World Markets
* Before the Bell Dow 30 Stocks
Redemptions will mean funds will dump these assets and forced selling could push up borrowing costs for businesses, choking them even further, Ashworth wrote.
In the UK, rates at zero may mean that savers will not feel any incentive to keep cash in long-term deposits, making it harder for banks to meet their regulatory liquidity ratios, economists from Investec said.
"What is currently more important than the price of money is the quantity of money," Investec's Philip Shaw wrote, adding that UK rates may get close to zero by the spring.
The Fed has already moved on from using interest rates as a monetary policy tool and the next fed funds target rate after the Dec. 16 meeting is "almost academic," ING economist Rob Carnell said.
The Fed's balance sheet has expanded to more than $2 trillion, made up of collateral received in exchange for liquidity provision, or loans of Treasurys.
"In our view, this is, for want of an alternative description, 'printing money'," Carnell wrote in his research. "And our assumption is that there is more of this to come."
Besides mortgage-backed securities and asset-backed securities, the Fed will purchase Treasurys, corporate paper and even stocks to provide much needed cash, he predicted.
"The Fed's only option is effectively to 'print money' by crediting the reserve balances held by commercial banks at the central bank," Ashworth also said.
Buying Treasurys would be the biggest weapon that hasn't been deployed yet, as such a policy means the Treasury could pump into the economy as much cash as it needs.
"There's no limit to the amount of money that the Fed can print and Congress can spend," Ashworth said.
But for some, that's a scary thought, as the amount of U.S. government debt is already staggering.
"Nobody really knows how these policies will work out," Stoeferle said. "If it were another country, the U.S. should probably declare bankruptcy."