Could the Fed keep rates at 0% into 2012? Some at the Fed think it should

06/15/2010 12:00 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

The Federal Reserve will hold its short-term interest rate target at 0% to 0.25% until 2012, according to a new research paper by economist Glenn Rudebusch.

That’s a much longer delay than Wall Street now anticipates. Estimates there for when the Federal Reserve will start to raise rates range from late this year to the first half of 2011.

It’s worth taking this new report seriously. Rudebusch is associate director of research at the San Francisco Fed so his paper, while by no means an official statement of Fed policy, is an indication of what some inside the Fed are thinking about interest rates. And in this case “some” most likely includes Janet Yellen, president of the San Francisco Fed and President Barack Obama’s nominee for the No. 2 slot to Chairman Ben Bernanke at the Federal Reserve.

What does the paper argue?

That the factor with the closest statistical relationship to core consumer price inflation isn’t short-term interest rates but the natural rate of unemployment. The relationship between short-term interest rates and inflation or asset bubbles is, Rudebusch writes, “quite erratic and poorly understood.” Japan has had very low interest rates for 15 years without producing either inflation or a financial bubble.

If the Federal Reserve had used unemployment to guide policy, Rudebusch writes, the central bank would have lowered the federal funds rate in 2009 by another 5%. That, of course, was an impossibility with short-term rates already at 0%.

But that does mean that looking at the current and projected rate of unemployment the Federal Reserve should keep interest rates near 0% until late 2012. “In practice, this suggests little need to raise the funds rate target above its zero lower bound anytime soon.”

This report isn’t Federal Reserve policy and there’s certainly no guarantee that this view, even if it is shared by Yellen, will carry the day. But I think it does suggest that if you were considering a bet on whether the Fed will raise rates sooner than Wall Street now expects or later than the consensus projects, that the best bet would be later rather than sooner.

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