All Fall Down: What if Fed Rates go to Zero?

If the Federal Reserve keeps cutting rates until they hit zero, it might stimulate the economy by boosting the housing market. On the other hand, dropping Fed rates to zero also may put us into an even more precarious situation by driving down the prices of goods and the value of the dollar, inviting ugly economic deflation.

The Federal Reserve is worried that if mortgage rates keep dropping, it might put dangerous pressure on money market funds. During the bleak weeks of September, as the stock market accelerated its dizzying descent, the value of some money market funds, which had traditionally always remained at a reliable value of one dollar per unit, slipped below that level.  In Wall Street lingo, they "got bucked," meaning that money deposited in funds actually lost value.

Money market issues frighten Fed

Money market shares are considered about the safest and most reliable investment around; but now, consumers have learned that they, too, are also subject to volatility and declines. When money markets made their unusual move, the Fed immediately rushed to reassure investors before depositors made a "run" on these accounts, by pulling out their money. If that were to happen, it could trigger a loss of confidence in the entire banking system and cause immediate widespread financial chaos.  Therefore, while the Fed may continue to whittle away at rates, some financial pundits believe that Federal Reserve Chairman Ben Bernanke will stop short of pushing them all the way to zero.

Down with deflation

What concerns the Fed the most, however, is the possibility that deeper rate cuts may cause economic deflation-a condition that happens when prices fall, due to a shortage of available cash. Deflation in prices causes consumers and businesses to curb spending as they wait for prices to fall further.  Without selling their inventory, businesses may go under, laying off employees and making the economic climate even worse. In such a scenario, the prices of goods and services would be cheap, nobody would buy them because they're strapped for cash, and consumer dollars would represent less value. One good example of deflation can be seen in our real estate market, where a lack of buying caused prices to tumble, but buyers still waited for prices to fall even further as they sat on the sidelines. Meanwhile, homes continue to go into foreclosure, which forced banks to curtail mortgage lending. A deflationary spiral feeds upon itself.

Japan suffered deflation for nearly a decade beginning in the mid-1990s.  Many blame the fact that its interest rates remained at zero for a prolonged period of time. Having learned from Japan's example, the Federal Reserve is moving cautiously, and has begun to take proactive steps, such as buying up debt from banks while supplying them with large infusions of cash. In that way, the Fed hopes to reign in potential deflation while it continues to battle on three gigantic fronts with aggressive threats from deflation, inflation, and recession simultaneously attacking our national economy.