The Fed did not want to cut the Fed Funds Rate below 2%. And because Congress recently granted authority for the Fed to pay interest on reserves, Bernanke thought incorrectly that he could keep rates above 2%. So much for that academic theory. Now many are wondering if ZIRP (Zero Interest Rate Policy) is coming to the Fed.

The LA Times addressed the question today in The Fed’s rate at zero? It’s no longer a far-fetched idea.

Just a day after the Federal Reserve dropped its key short-term interest rate to 1% — matching the generational low reached in 2003-04 — the betting is intensifying on another cut.

Trading in futures contracts on the federal funds rate, the Fed’s benchmark, implies a 51.4% probability that the central bank will slash the rate to 0.50% on or before its next meeting on Dec. 16, according to Bloomberg News data.

Rate expectations may be cueing off the government’s report today that the economy shrank at an annualized rate of 0.3% in the third quarter. Although analysts figured the economy had contracted in the period, the details were ugly — particularly the 3.1% decline in real consumer spending, the biggest drop since the vicious recession that began in 1980.

The Bank of Japan had to maintain its benchmark interest rate at or near zero for most of the 1999-2006 period, before policymakers finally felt comfortable that the economy was in a sustainable recovery.

December FOMC Meeting Implied Probability

Chart courtesy of Cleveland Fed.

Rate Cuts Counterproductive

There was an interesting discussion on Minyanville today about rate cuts. Minyan Peter offered the following thoughts.

With Fed Funds already trading at 1.00% prior to the announcement, it will be critical to watch whether other short term indices drop by 50 bps, particularly LIBOR and, probably most importantly consumer deposit rates.

If short term bank liabilities do not reprice down by at least the 50 bps cut in the prime, contrary to public perception, banks will now be worse off than they were before yesterday’s announcement. … If yesterday’s rate cut in any way squeezes margins, further cuts will only compound the problem. … I would offer that future Fed Funds cuts are off the table.“

It seems that those rate cuts are squeezing margin and will continue to do so, especially on those taxpayer funded capital injections. The terms on the preferred shares were 5% escalating to 9%! (See Compelling Banks To Lend At Bazooka Point for more details on the capital injections)

The prime lending rate is now 4%. Banks are guaranteed to lose money on that $250 billion Paulson forced down their throats if they lend it out to their least risky clients at prime.

Is it any wonder banks are reluctant to lend it? Instead banks are opting for mergers where they can cut employees to reduce costs. The NY Times made this sound like a conspiracy (See NY Times Lending Conspiracy Madness) To me it sounds like unintended consequences of the bailout plan.

Key Interest Rates

Chart courtesy of Bloomberg.

So banks are paying 3.65% on one year CDs. Prime rate is 4.0%. Where is the profit? Take overhead into account and there isn’t any. So why the high rates on deposits? The answer is banks are all competing with each other for capital. They need it to cover future losses on credit cards, foreclosures, REOs (bank owned real estate), commercial loans, etc.

ZIRP did not help Japan and it will not help US banks either. In fact, the rate cuts appear to be counterproductive. However, one cannot rule out the Fed cutting rates to 0% anyway. Bernanke is in academic wonderland and appears to be hell bent on sticking with his models regardless of how poorly those models perform in actual practice.

Mike “Mish” Shedlock
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