/www.bloomberg.com/ By Craig Torres
Washington, March 10 (Bloomberg) -- The Federal Reserve may opt for unconventional tactics, such as direct purchases of Treasury notes, to fight deflation should a possible war with Iraq weaken an already flagging U.S. economy.
Word that the nation lost 308,000 jobs in February raised odds that the Fed next week will cut its benchmark interest rate by a quarter-point to 1 percent, the lowest since July 1958. Even that may not be enough to keep the economy growing if a war starts and takes too long to resolve, some economists said.
``Another rate cut will do little to support the economy,'' Merrill Lynch & Co. chief economist David Rosenberg told clients last week. A new strategy involving purchases of intermediate and long-term Treasury securities ``could soon be put in place,'' he said. Rosenberg put the odds of a recession at 50 percent and predicted a second rate cut, to 0.75 percent, by May.
A central bank move to buy 10-year Treasury notes would lower interest rates on those securities, as well as on corporate bonds and consumer mortgages that are priced off of government yields, and pump more cash into the banking system. Economists consider such measures unconventional because the Fed hasn't targeted Treasury note yields since World War II.
Both Chairman Alan Greenspan and Governor Ben Bernanke have said the Fed could switch to purchases of longer-term Treasuries as its main overnight bank lending rate approaches zero.
``A central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition,'' said Bernanke, who is in charge of economic research at the board of governors, in November. ``One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure'' through direct purchases of notes or bonds.
War Prospect
The prospect of war is disrupting an already jagged economic recovery, and for some economists raising the likelihood of further interest-rate cuts.
The 308,000 jobs lost in Friday's Labor Department report was three times the monthly average in the recession year of 2001. Private surveys showed that growth slowed in manufacturing and service industries in February and that consumer confidence sank to a nine-year low in January.
Greenspan told Congress last month that the removal of Iraq tensions would release pent-up demand for investment spending, and Fed officials have also cautioned that it is impossible to predict the economic impact of any war.
``The most important stimulus is the removal of uncertainties which overhang the capital investment markets,'' Greenspan told the Senate Banking Committee.
Benchmark 10-year Treasuries yields tumbled to within 5 basis points of a 45-year low last week as investors sought the safest credit as expectations of war build. The 3 7/8 percent note maturing in February 2013 rose 1/8, or 1.25 per $1,000 face amount, to 101 15/16 Friday, lowering yields 2 basis points to 3.64 percent. Yields fell as low as 3.58.
Fed Meeting
Fed policy makers meet March 18 to set the benchmark federal funds rate, which has stood at a 41-year-low of 1.25 percent since November. Economists said they expect at a minimum that the Fed will change its outlook statement to cite risks of additional economic weakness. Futures on federal funds show expectations of a 0.25 percent reduction at the May Fed policy meeting.
Economists at Merrill Lynch, J.P. Morgan Chase & Co. and HSBC Securities, three of the 22 primary bond dealers that trade directly with the central bank, are among those forecasting a quarter-point rate cut next week. While that view for now is shared by just four of 30 economists in a Bloomberg News survey, more forecasters may join them if other economic reports this week fall short of predictions.
`No Tolerance'
``The Fed has no tolerance for downside surprises at this point,'' said Lou Crandall, chief economist at Wrightson ICAP Associates, the economic research arm of ICAP Plc, the world's largest broker of trades between investment firms. Crandall also predicts the Fed will cut rates next week. ``The costs of being wrong are too great on the downside.''
Fed officials have said that the dozen rate cuts since January 2001 helped the economy by shoring up consumer pocketbooks. Mortgage rates fell, reducing debt payments, and consumers extracted some $700 billion in equity through home sales, refinancings and home equity loans. Greenspan also said he expects to mortgage boom to ``simmer down'' in 2003, which could remove an important source of stimulus to the economy.
The U.S. isn't getting much help in the form of export demand from foreign economies either. The European Central Bank on Thursday cut its benchmark interest rate by a quarter-point to 2.5 percent, the lowest in almost 3 1/2 years, amid rising unemployment and faltering consumer confidence.
Changing Strategies
The question now is whether another knick at short-term borrowing costs is enough to counter the collapse in consumer confidence, a fourth straight year of stock market declines, and a perhaps soaring energy prices should a war drag on for months and disrupt oil supplies.
Crude oil prices hit a 12-year high last week, a situation that constrains consumer spending because of higher prices for gas. Public transportation costs, such as taxi fares in Washington, are also rising. The Standard & Poor's 500 Stock Index is down 5.6 percent year-to-date, following three consecutive annual losses that took the index down 40 percent.
Capping long-term interest rates would have one central goal: To kick start spending by artificially lowering long-term borrowing costs. Economists said a move to buy Treasuries would most likely be a response to the risk that deflation was spreading through the economy, and not simply a shift in tactics.
``Continuing sub-par growth means we could be getting additional economic slack and some serious disinflation when we don't really need it,'' said Michael Prell, the Fed's policy committee's former chief economic forecaster.
Deflation
Deflation is a general decline in prices, and it is considered to be harder to reverse than inflation. Profits collapse because the price of goods falls faster than manufacturers can lower the cost to make them. Lending can seize up as the value of collateral declines, leaving banks with loans worth more than their underlying assets.
While Fed officials have called the risk of deflation in the U.S. ``extremely small,'' goods producers ranging from clothing makers to car companies did experience price declines last year. Prices of services, such as medical care, were generally higher, which is why overall inflation, minus food and energy prices, rose by 1.9 percent, according to the consumer price index. This mix of slight price gains in some sectors and falling prices in others to produce a low, even declining rate of overall inflation is what economists call disinflation.
Billions of Dollars
Influencing longer-term Treasury yields would take billions of dollars of purchases by the Fed, so the banking system could also be flooded with cash. While that would create its own set of challenges, such as driving the fed funds rate to zero anyway as banks tried to sell excess reserves, economists consider the move as a viable option in a time of economic stress.
After all, the Fed targeted long-term Treasury bond rates during World War II at 2.5 percent.
``If there is conflict in the Middle East, the fed funds rate in effect would become irrelevant anyway,'' said Robert Gay, head of fixed income and credit strategy at Commerzbank Capital Markets. ``Under circumstances of financial stress or war, the Federal Reserve stands ready to provide all the liquidity that the financial markets need, no questions asked, no penalties, no keeping track.''