What will the Fed do next now that rates are at zero?

The Fed has been attempting to resuscitate the deflationary housing market through traditional monetary tools, but recently it ran out of ammunition when Federal Funds rate dropped to zero. The traditional methods of manipulating money supply have been exhausted-open marrket operations, the discount rate, and reserve requirement. These conventional tools are aimed at affecting the short term rates with the hopes that the longer term rates will also adjust accordingly. The hopes never materialized and this left the 30 year fixed mortgage rates stubbornly high relative to the three month t-bill.

The Fed then moved to an unconventional monetary tool called quantitative easing. Quantitative easing is the attempt to loosen the credit markets by purchasing bank assets that are priced at the long end of the yield curve such as mortgage backed securities. The only precedence for this technique in modern history was Japan. They used quantitative easing to help prevent deflation after their overnight interbank lending rates dropped to zero during the 1990’s and early 21st century.

The Fed’s unconventional technique has worked in helping lower the mortgage rates. Recently, the 30 year fixed mortgage rate tested a 37 year low of 5.19%. The Fed has committed $100 billion and spent $15 billion thus far to purchase MBSs from Fannie and Freddie in the hopes of loosening up the mortage markets to spur borrowing again. While the traditional monetary tools have proved ineffective, the Fed has targeted a different means of fulfilling its dual mandate of growth and price level, quantitative easing.