How the Fed is Setting a Policy Rate of, oh, -5%

♠ Posted by Emmanuel in , at 4/27/2009 01:17:00 PM
I do not call foreign exchange movements "special FX" for nothing as they often display more nonsensical gyration than your average episode of Dancing With the Stars. Here is another case in point: the US dollar has strengthened to start off the week despite revelations that the Federal Reserve is keen on replicating easy money conditions similar to having a policy rate of -5% by the Taylor rule based on prevailing inflation and employment trends. From the Financial Times:
The ideal interest rate for the US economy in current conditions would be minus 5 per cent, according to internal analysis prepared for the Federal Reserve’s last policy meeting. The analysis was based on a so-called Taylor-rule approach that estimates an appropriate interest rate based on unemployment and inflation.

A central bank cannot cut interest rates below zero. However, the staff research suggests the Fed should maintain unconventional policies that provide stimulus roughly equivalent to an interest rate of minus 5 per cent. [Think of various facilities clogging the Fed balance sheet with bank detritus and active intervention in bond markets.]

Fed staff separately estimated what size and type of unconventional operations, including asset purchases, might provide this level of stimulus. They suggested that the Fed should expand its asset purchases by even more than the $1,150bn (€885bn, £788bn) increase policymakers authorised at the last meeting, which included $300bn of Treasury purchases.

The assessment that the US central bank needs to provide stimulus equivalent to a substantially negative interest rate is unlikely to have changed ahead of this week’s policy meeting.
What the Fed is doing is undoubtedly nasty for America's creditors given the implications of such interest rates for the US dollar going forward. Plus, it is uncertain if this debt-fueled frenzy can be turned off at the flick of a switch in the equally uncertain event of a US recovery. Was Larry Summers again sleeping on the job when he told the Chinese that the United States was a "sound steward" of PRC investments? Once more, we should ask ourselves: Who's the bigger fool--the free-spending fool or those fooled by the free-spending fool? Maybe it's just me but buying assurances that your investments are safe from a country hellbent on giving you a -5% rate of return does not seem to be a very intelligent decision.