Will the Fed's Rate Cut Help? The Japan Lesson

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Manuel Balce / AP

Federal Reserve Chairman Ben Bernanke

The U.S. Federal Reserve cut its benchmark interest rate by 50 basis points to 1% on Wednesday, continuing an aggressive effort to fend off a deep recession. The rate now stands at the lowest level since 2004 — and central bankers signaled that they may resort to more cuts in the months ahead.

The hope is that further rate cuts will stabilize volatile financial markets and accelerate the slowing economy. But as the rate heads toward zero, the Fed is rapidly running out of room for reductions. Not only that, economists and analysts are questioning whether rate cuts produce any bang for the buck under the current extraordinary circumstances.

In a normal cyclical slowdown, lowering interest rates encourages fresh business activity by reducing the cost of borrowing from banks. With more borrowing comes more investment, more jobs and more growth. But these are far from ordinary times. Banks, already burdened with bad consumer and commercial debts, are desperate to clean up their balance sheets and avoid risk — they are not eager to take on more risk by issuing new loans against the backdrop of a deteriorating business climate. American consumers, too, are trying to reduce household debt, so borrowing more money for a new car or to remodel the kitchen is not a high priority. And without greater consumer spending, most companies have little need for new loans to expand operations. "Interest rate cuts don't matter in this environment," says Kirby Daley, senior strategist at financial-services firm Newedge Group in Hong Kong. "It doesn't get at the heart of the issue."

Japan discovered the futility of ultra-low interest rates in the 1990s, when the Bank of Japan (BOJ) tried to prod the country out of a protracted recession by lowering the rate all the way to zero in 1999 — where it stayed, with one brief interlude, until 2006. Despite the fact that lenders could essentially get free money from the government, Japanese banks were busy recapitalizing and paring down mountains of bad assets, and had little interest in doling out more loans in a moribund economy. The zero-rate policy did little to stimulate growth.

Analysts in Japan say the U.S. faces a similar situation today. The Fed's recent rate cut "is better than doing nothing, but it will unlikely work so much as it did in the past," says Masaaki Kanno, chief economist at JPMorgan Securities in Tokyo. Hiromichi Shirakawa, chief economist at Credit Suisse in Tokyo, believes that the Fed may bring its rates down to zero by the middle of 2009, as the U.S. economy slows in coming quarters. "Will it be effective or stimulative? My answer is not necessarily so," he says.

Still, central bankers around the world, in an effort to ward off the worst effects of a global economic slowdown, appear to be engaging in a rate race to the bottom. China on Oct. 29 cut its interest rates for the third time in six weeks, and the BOJ is expected to cut its key policy rate below the current 0.5% soon. Though rates in Japan are already almost nil, Tokyo's hand is to an extent being forced by Washington. That's because as U.S. rates fall, fewer investors are willing to hold U.S. dollar debt, which undermines the value of American currency vs. the yen — and a stronger yen is bad news for Japan. It makes the country's exports more expensive, curtailing economic growth. Credit Suisse's Shirakawa believes the chances of the BOJ returning to a zero rate is less than 50%, "because they know that a return to a zero-rate policy doesn't help the economy much." But, he says, "they know that the risk is that the yen appreciation will be quite significant if they don't move."

According to Japanese analysts, U.S. Federal Reserve Chairman Ben Bernanke may decide that it's best to lower rates again, to below 1%, in the coming months as the economy weakens. Even though ultra-low rates may have little immediate economic impact, they help to stabilize the financial sector as well as stock markets. Equities become more attractive when interest earned by stashing cash in the bank is lower than the inflation rate. "While the BOJ's zero-rate policy did not work as expected in terms of reviving the economy, it contributed to preventing the financial system from collapsing," says JPMorgan's Kanno. The U.S. may soon find itself in a strange, zenlike economic state in which zero is, in fact, better than nothing.