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Why Permanent Zero is toxic and leads to depression

By now you should have seen my post indicating I believe the Fed has already begun its third easing campaign. What the Fed has done is told us it would keep the Fed Funds rate at effectively zero percent through mid-2013, two years from now. This is one step short of ‘rate easing’, the term I am using to describe a Central Bank’s targeting a specific non-policy rate, a form of quantitative easing where the Fed targets price instead of quantity.

While rate easing and its cousin permanent zero might have some salutary effect in the short term, these policies are toxic to the financial sector and consumption demand. Likely, they will not spur the economy but lead to a deepening malaise.

Fed monopoly power

See, the Federal Reserve is a monopolist. It has sole control of the price of base money via its policy rate. The Fed sets the Fed Funds rate and the financial sector must accommodate this rate. But this is only true for base money which is an interbank market for overnight borrowing of bank reserves. The interest rate – that is to say, the price of money – for longer-term lending arrangements is set by the marketplace. For example, the Treasury bond market is the most liquid bond market in the world where buyers and sellers transact in much the same way they do in the stock market to determine the price and yield of Treasury bonds.

There is a connection to the policy rate, however, because any interest rate can be represented as a series of shorter-duration expected future interest rates.

For example, say you know the 5-year rate by looking at the current on-the-run 5-year interest rate on Bloomberg. Then, all you need to calculate all the expected future expected 3-month rates are quotes on U.S. zero-coupon bonds known as Treasury STRIPS. They are quoted in the Wall Street Journal daily.

So in a very real sense, the Fed exerts a dominate influence on the entirety of American credit markets. The policy rate affects the entire term structure of interest rates. Clearly though, interest rate policy expectations become more variable as the term structure lengthens and other factors come into play. The Fed plays a dominate role but the market sets the price of 30-year treasuries based on the collective view of expected future policy rates and the risk associated with that policy path.

Defining rate easing and permanent zero

The Treasury market is pretty well defined. In the two- and three-year space, yields aren’t moving for the next two years. The question becomes 10- and 30-year bonds. Investors need to decide between the value of a 30-year U.S. Treasury and bonds of countries like Canada and Australia that have slightly higher yields. We want to make sure those higher-yielding countries are safe. We consider places like Germany, Australia and Canada "clean dirty shirts," in that they are safe and their bond yields, while low, are still more attractive than Treasuries. If the global economy tips into recession, the safest place to be is in the cleanest dirty shirts. Our best idea therefore is a 10-year Australian or Canadian bond. A 10-year Canadian government bond yields 2.5%. A 10-year Aussie bond yields 4.5%.

-Bill Gross, Barron’s

In making his investment outlook thesis in Barron’s this past weekend, Bill Gross was telling us that the Fed has anchored his interest rate expectations. “In the two- and three-year space, yields aren’t moving for the next two years.”

When I talk about ‘rate easing’ or ‘permanent zero’, I define them as distinct concepts. With permanent zero, the Fed comes out and says something like:

“The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate”

And then they define a period.

With rate easing, instead of defining a period of policy accommodation, the Fed comes out and says explicitly that it will not let interest rates on Treasuries rise above a specific target level and they define the Treasury maturity.

Last month I speculated that the Fed would move to QE3, but only when the economy was in or near recession. I felt the Fed would avoid terms like ‘quantitative easing’ for political reasons and, therefore, avoid outright rate targets until the economy was in recession.

My sense is that this will not be called quantitative easing or credit easing or anything like that. Those terms are dead because they are now politically radioactive. But operationally, the policy will be the same. This time the Fed will target price instead of quantity…

P.S. – The Fed is likely to soft peddle this policy change… The Fed will want to stay to the shorter end so as not to risk its balance sheet by moving out the curve with interest rate caps. However, there could be internal dissent, so the Fed could start off by signalling to the market that it will conduct what I have been calling ‘permanent zero’.

But the Fed was pretty aggressive in my view. two years is a very long time. To me, this is as close as you’ll get to full-blown rate easing – and I said so on Sunday.

Toxic for savers

Unfortunately, the low nominal rates of rate easing and permanent zero are toxic over the long-term. We know that from Japan where these conditions exist.

Remember, Japanese government debt to GDP is 200%. It’s not like the Bank of Japan would actually want to raise rates. As I wrote in March:

  1. Japan’s long-term rates reflect private portfolio preferences as determined by expected future interest rates… So 10-year rates are low because expected inflation and expected future short-term rates are low.
  2. Japan’s Debt to GDP is over 200%, meaning that any uptick in expected future short-term rates due to inflation would be disastrous in terms of interest due.
  3. So, to avoid this scenario, Japan must leave short-term interest rates at near zero percent or risk the crowding out of public spending that higher interest payments would entail. Only if the debt to GDP ratio declines significantly can it relax this stance.

So, this means the Japanese elderly have to save a lot to make ends meet in a retirement where long-term yields are minimal. Some have turned to theft. (See update at the bottom recanting this somewhat)

Question: should we expect a different outcome in the U.S.? The last post I wrote on the housing and foreclosure crisis highlights a CBS video about declining house prices and a foreclosure epidemic in the U.S. Isn’t this an environment that lends itself to permanent zero? And If long rates are largely determined by expected future short rates, the longer short rates are at zero percent, the lower long rates will go. That’s toxic for bank interest margins.Look at 77 bank as an example.

-Punishing Savers and Theft Amongst the Elderly

Toxic for banks

I’ve already written this up so I’ll just quote from the piece:

I am starting to take the view that the Fed is reducing net interest margins. Back in 2008 and 2009, US banks benefited from low rates as their net interest margins were huge. For the first quarter of this year, JPMorgan Chase even had a negative net borrowing rate of interest while it made 324 basis points in net margin. They were effectively paid to borrow, leading to a more than 3% interest rate spread on loans. That’s a great story. Can it last, though?

The short answer is no. As the long end of the yield curve comes in due to either QE or what I have been calling permanent zero (PZ), as zero rates become a permanent state of affairs, interest margins have compressed. Rates will compress even more the longer rates stay at zero percent because the expected future rates will start to come down (see here on bootstrapping the yield curve).

What’s more is that PZ will be a big problem in a Shiller double dip scenario because banks will be set up for huge loan losses despite recent under-provisioning. Meanwhile they will have no way to make it back on net interest as long rates come down in a recession while short rates remain at zero percent, killing net interest margins.

This is the problem with QE and PZ money: it works in the short run, but is toxic in the longer-term. Now if liquidity was the real problem for banks, then the banks will have enough capital to ride through this. They will recover as many did in the early 1990s during the last banking crisis in the US.

If solvency is the banks’ problem, QE and PZ will be toxic.

-How Quantitative Easing and Permanent Zero are Toxic To Bank Net Interest Margins

To me, the probability of a Shiller double dip seems even more likely than it did last year and of course that has been my baseline scenario for two years now. If we do get this second recession, Fed policy will be toxic because the yield curve will stay flat just as it has in Japan.

When recession hits, over-indebted consumers will be forced to delever aggressively and consumption demand will crater. This will invite an even more aggressive policy response from the Fed which could include the purchase of municipal bonds among other more drastic measures. It will be, as FT Alphaville puts it, “Desperate measures for *really* desperate times

The bottom line is this: easy money will not create sustainable growth.

Update 2145ET: John Hempton rightly pointed out the following about saving in Japan’s deflationary environment to me by e-mail saying the implication that the low returns turn old people in Japan to theft is just flat wrong:

In Japan there has been about 4 percent DEFLATION for twenty years. That means that cash-in-the-bank yielding zero has a 4% post tax real return. 4% post tax real is better than the US stock market (one of the better ones in the world) for the whole of the 20th century. It’s way better returns than most Americans earn (though less than they think they can earn)…

The point is that in a true smash-em-up liquidity trap the savings at zero percent are perfectly rational. There is no need or desire to chase yield because 4% post tax real is about as good as you get. Anywhere.

In a deflationary environment this works, yes, because it is about the real return. So, John’s right – point taken on Japan (although 4% CPI deflation since 1990 doesn’t sound right). I would say, however, an eroded social safety net is very much still a factor. In the US, the situation is different, however. The point holds for savings and the soon to be eroded social safety net. If the US moves from the present mode of financial repression into outright deflation, my points about savers being robbed won’t hold and John’s points will be more important.


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.


  1. PBlacque says:


    Nice summary. But surely the Bernankes of the world have thought this through as well and have reached, one has to believe, similar conclusions.

    So what gives? Are they intent on self-destruction?

    I remember Bernanke basically saying that short of further FISCAL stimulus, there was little monetary policy could do now…

    So is Bernanke kicking the ball in Congress’ court so as not to be “more political”? I think so.

    On another front, is not the PZ net interest rate compression intended to force banks out of the easy yield curve play, to relax their lending standards and to take on more traditonal credit risks?

    Not sure how that can work in a liquidity trap… but “gotta do something” must be their thinking. It might help at the margin.

    The real question is where are the Public and Private leaders? It’s clear the private leaders have to come out and force the fiscal issues (job creation, more tax revenues, etc.) on public leaders… and they’re starting to do just that. That’s our only hope.

    • Bernanke is going to have to go through the motions. It’s not like he can sit on his hands. Kocherlakota and Plosser can dissent all they want but if the economy tanks while the Fed just sits there, there will be hell to pay. They are damned either way. So Bernanke will just have to drive along the path that he thinks will be least damaging economically and/or politically.

      • PBlacque says:

        Right… but we both agree that whatever he comes up with will fall short of what’s required and … he sort of said so himself. And the pressure is now on politicians to sort it out… thus I think Congress will blink first…

        BTW, what would a Helicopter campaign look like?

  2. NOTaREALmerican says:

    Re: The bottom line is this: easy money will not create sustainable growth.

    Does anybody even know what “sustainable growth” is? Have we ever had it (say, in post ww2 times)? Has anybody else? Can an “export economy” be considered “sustainable” IF everybody can’t export to everybody else forever “sustainably”?

    Bonus questions: is it possible to have “sustainable growth” with a crony-capitalist/centrally-planned political system? Is the EU as crony-capitalist as the US is (meaning, was EU actually created to “implement” US-style central-planning/crony-capitalism in Europe)? Is there any other political/economic system possible other than crony-capitalist/centrally-planned?

    • fhl says:

      Yes, there’s the Kingdom of God system.

      It’s coming up shortly and it will last a thousand years.

  3. yo says:

    Ok, so the banks really didn’t care whether there was deflation or inflation. All they wanted to do was lock in a three point spread.

    But, if the spread goes away, what are they going to try to do under the two scenarios of deflation or inflation. One of them is going to happen and the banks will have to do something because they gots no spread, man.

  4. yo says:

    What are the banks in Japan investing in. How have they survived for twenty years. There must be a story there somewhere. They got no spread and they’re still kicking after twenty years?

  5. Jim Haygood says:

    Your skepticism of John Hempton’s claim about ‘four percent deflation for twenty years’ in Japan is well-founded. It’s utter nonsense.

    The hard fact is that Japan’s CPI was at 97.1 in June 1991, and has RISEN to 99.9 as of June 2011, twenty years later. You can obtain the monthly values I just quoted at this link, under the heading ‘Historical CPI Index for Japan.’

    There is no example in planetary history of a 4% annual deflation that prevailed for 20 years. What kind of a flake would make up such a fantasy? He was setting you up, Ed — and he got away with it!

    • Zac says:

      Your right Jim but maybe John Hempton is right too. If you take official inflation numbers (as you did) or GDP numbers you are absolutely right but if you take stock market decline and real estate market decline through 20 years then Hempton is right.
      More than 50% 2011/1990.

  6. Zac says:

    everybody looks at last 20 Japanese year’s as failure but was it?
    I would say they managed to preserve stability although economy was working below pontential. In last 3 year’s you could hear from MSM just words like : dissaster, armagedon, end of the world… Keynes, in his great book, was indirectly speaking of optimism as one of main componens for stabilisation without it there would be no recovery. So there is an option to sort this things quietly (like in Japan) or … I agree with this article and liquidity trap but from Japanese expirience you should target corporate sector savings, and US corporate sector is in far better shape then Japanese were in 1990. Ok there is no tool for that (I suppose?)and large US companies are globalised so opportunistically they will invest abroad and create jobs in EM. So we are back to the starting point : sub par growth or new normal (as you like) like in Japan or high inflation with possibility of…or third path full fledged deflation, for me worst case scenario. For deflation (debt – deflation – hyperinflation – poverty) and globalisation, I will put again Keynes in context : after WWI Weimar republic was forced to pay unpayable reparation which they funded by loans from (primary) US banking system after 1929 funding whidrawed from Germany. In 1919 Keynes wrote : “The Economic Consequences of the Peace” arguing that it was “Carthagian peace” (all three Punic wars were nominaly started by Carthaga but in reality by Rome). For Globalisation : in 1944 at Bretton woods he predicted globalisation and argued for one single world currency… That would enable (partly : because languages, education, tradition diff)globalisation. Partly as in former Yugoslavia they had single currency but differences were to huge and some parts of country were so economically backward that were continously on huge transfer payments.
    To conclude globalisation could not work just for big companies and without anything else sooner or later it will produce unstability, or one (peged) country cannot always be net exporter and another net importer again we have unstability.
    For deflation : there is obligation to pay down debt but every coin have to sides, you will never hear on MSM or mayority of blogs that there is also responsibility of provider of debt.
    For example I’m creditor and I should also participate if I gave someone credit who is not creditworthy althoug rating agencies gave him investible rating it is my decision to give him credit (shame on me to trust those agencies, by the way those agencies are now like firefighters who are pouring gasoline on fire). So it is mutual problem.
    To conclude althoug he is a central banker all best to Mr. Bernanke.