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Fed Shoots for Target Range


Non-fixed funds rate allows room to maneuver.


The Federal Reserve has taken interest rates to 0. They've clearly started a program of quantitative easing, but what exactly does that mean? Is the Fed pushing on a string, as Japan has done for almost two decades? The quick answer is no, but that doesn't tell us much. We may not be in for a 2-decade-long Japanese malaise, but we'll experience a whole new set of circumstances. In what will hopefully be a shorter holiday version of the e-letter, I'll tackle these questions and more.

I Meant to Do That

In my house, when someone stumbles or makes an odd move, they quickly say, "I meant to do that." It's a running joke, and we all have fun with it.

This week, the Fed pulled one. Quoting from the release after their 2-day meeting: "The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 0.25%."

Normally, they have a specific rate, not a range. But for the last few weeks, the market has pushed the Fed's fund rate close to 0, making the Fed look like they were behind the curve at the then-official rate of 1%.

With a range rather than a specific rate, the Fed can fall back on, "I meant to do that." They can keep the Fed funds rate from rising over 0.25%. And if it stays near 0? Well, then they can say it's within the target.

And with Fed funds at an effective 0, it's bringing down other rates as well. I wrote in 1998 -- and have repeatedly made the point over the past 5 years -- that deflation, not inflation, will be the primary force that must be dealt with before we're finished with the current credit cycle. Over the last year, when Consumer Price Index (or CPI) inflation was high and rising, I kept insisting that the problem would be deflation in 2009 - bringing lots of letters insisting I was wrong. I've long held that, ultimately, interest rates on the US 30-year bond would fall below 3%. That was a rather bold idea in 1998, and even last year.

Now, that prediction seems rather tame. We went right through 3% this week; as I write, we're at an astounding 2.54% on the 30-year and 2.1% on the 10-year.

Click to enlarge

Note that the 3-month is at 0. Indeed, to get even 1% you have to go all the way out to a 3-year maturity. This is going to make it very hard on money-market funds to offer any type of yield. Indeed, several large firms have closed their Treasury money-market funds, as it costs more to operate them than the interest paid on the bills, notes, and bonds.

This is precisely what the Fed wants to see. Investors will need to start looking to other avenues to get yield. If you can't get a return on your money market, why not put it in a bank certificate of deposit? You can get a federally-insured CD for 1 year at over 3% at many institutions, and 4% if you want to tie your money up for 3 years. Making the competition less profitable is one way to recapitalize banks.

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