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Friday, July 04, 2003

ZIRP and Moral Hazard

Morgan Stanley's Takehiro Sato muses over possible dilemnas which may be facing the US monetary authorities in a non too distant future. His points follow closely on my post about the Greenspan put. Nothing here is easy, and timing is everything. Greenspan has avoided for now the ZIRP zone, but only at the cost of a surge in long rates which could in turn choke off growth and send him back towards ZIRP. No free lunches here, and I am not optimistic. Like Sato, my feeling is deflation will hit the US one day or another.

Restricting its rate cut to 25 basis points at its June 24-25 FOMC meeting, the Fed seems to have avoided an early entry into a zero-interest-rate (ZIRP) environment. ..............

Rather, the basic situation is becoming similar to that in March 1995, when the BoJ was confronted with a severe backlash to its smaller-than-expected rate cut, in the form of extreme yen appreciation and a sharp decline in equity prices. Similarly, the Fed recently received its own baptism by fire in the form of the sharp rise in Treasury yields. The Fed seems to have avoided an entry into a ZIRP environment based on its knowledge of Japan’s economy and financial markets. However, raising long-term interest rates carries the risk of reversing the positive recent shift from housing investment to personal consumption, which has effectively been holding up the US economy, something which the Fed cannot afford to ignore. In my view, US monetary policy looks set to slide toward long-term interest rate-targeting via verbal intervention. Looking further ahead, since much of the efficacy of monetary policy is nullified by deflation, and deflation looks to hit the US sooner or later, I personally still see a sizable risk that the central bank will slip into ZIRP in order to combat deflation.

ZIRP, however, is a very unconventional policy, with many negative side-effects. In Japan, ZIRP has not only failed to achieve its original goals, but may have even contributed to deflationary concerns. For example, Japan’s experience with ZIRP demonstrates that central bank influence becomes limited after easing short-term rates to zero in a deflationary environment. Furthermore, the outcome of ZIRP in Japan called into question the effectiveness of unconventional easing in general. While the BoJ’s unconventional easing initiative succeeded in containing systemic risk initially, its policies have since preserved excess supply without thought for the effectiveness or purpose of such excess capacity. Such a policy has drawn domestic banks into an inescapable predicament.
Source: Morgan Stanley Global Economic Forum

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