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Mauldin Shilling Article

Mauldin Shilling Article

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Published by: richardck61 on Sep 28, 2011
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 Absolute Zero
(excerpted from the September 2011 edition of A. Gary Shilling's
 )In its written release after its August 9 Federal Open Market Committee policy meeting, theFed included a statement that was highly unusual because of its specificity. “The Committeecurrently anticipates that economic conditions
including low rates of resource utilizationand a subdued outlook for inflation over the medium run
are likely to warrant exceptionally low levels for the federal funds rate at least through mid 2013.”In the recent past, the Fed has stated its plans to keep rates low for an “extended period,”but we can’t recall the central bank ever being this precise on any policy. The statement wasalso significant because it means that unless the economy takes off like a scalded dog, theovernight federal funds rate will continue close to zero, its absolute bottom. Notsurprisingly, longer term Treasury rates dropped on the announcement. The 2-year noteyield fell to 0.185%, an all-time low, and the 10-year note yield hit 2.033%, below theprevious 2.034% low reached on Dec. 18, 2008, after the collapse of Lehman Brothers droveinvestors to the safe haven of Treasurys.
Not Alone
 The Fed is not alone in keeping central bank short-term rates close to zero ( 
Chart 1
 ) inresponse to sluggish and declining global economic growth and the inability of massivemonetary and fiscal stimuli to revive economic activity. The outlier among major centralbanks is the ever-inflation wary European Central Bank, the spiritual descendant of theGerman Bundesbank and based in Frankfurt, Germany, for good reason. The ECB raised itstarget rate in April and again in July to 1.5% in response to Eurozone consumer inflationabove its 2% annual rate target for the overall index. Nevertheless, ECB President Trichetapparently has put further increases on hold and may later cut its rate in response tounfolding weakness and persistent financial turmoil in Europe.
Zero interest rates are significant for several reasons. Zero is the floor below which ratesnormally don’t fall, although the 3-month Treasury bill rate recently was negative amidstinvestors’ mad rush for liquidity and the safe haven of government paper. More importantly,at zero interest rates, strange things happen in security, currency and commodity marketsthat don’t fit normal rules. This doesn’t mean that actions are illogical and don’t follow rational behavior, but rather that the rules of difference. Most observers don’t understandthoroughly the new norms, their causes and effects. Most significantly, central bankers andfiscal policy managers don’t seem to either, which makes forecasting the outcome of theiractions and the unintended consequences extremely difficult.
How We Got Here
 You’ll probably recall how the Fed got to its current federal funds target of 0-0.25%. In early 2007, the subprime residential mortgage market started to fall apart. By August, the Fed hadcut its discount rate and the federal funds target rate shortly thereafter, initiating the declinesthat resulted in the current levels.In 2008-2010, in what became known as QE1, the Fed bought $300 billion in Treasurys,$1.25 billion in residential mortgage- related securities and $100 billion in Fannie Mae andFreddie Mac securities in an attempt to further prop up the faltering housing market andreduce mortgage rates. But these efforts were of little aid to the housing market, and pricesresumed their decline in mid-2010 after the effects of the tax credits for new home buyersexpired. So, in August 2010, Fed Chairman Bernanke hinted at QE2, which wasimplemented in late 2010, ran through mid-2011 and initiated the purchase of a netadditional $600 billion in Treasurys.

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