The Fed's Zero Problem : Planet Money The Fed has one key policy tool at its disposal: Interest rates. And the closer rates get to zero, the less the Fed can do to fight unemployment.
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The Fed's Zero Problem

If the Federal Reserve wants to fight unemployment, it has one major tool at its disposal: Lower interest rates. That's it. The basic idea is that lower interest rates encourage people and companies to borrow and spend.

To that end, the Fed has already lowered short-term interest rates as far as they can go — to zero — and all but promised to keep them there for two years.

And there's a good chance that the Fed will soon continue with its effort to push-down long-term interest rates, by replacing some of the short-term bonds it owns with long-term bonds. (Here's more on that from today's WSJ.)

But long-term interest rates are already super low. In fact, just this week, the interest rate on mortgages and 10-year Treasury bonds hit all-time record lows.

This presents a problem for the Fed. The lower rates go — the closer they get to zero — the harder it is to push them down further, Joseph Gagnon, a former Fed economist who is now at the Peterson Institute, told me today.

"It's going to be very hard to push 10 year Treasury yields much lower," he said.

Very hard does not mean impossible. Gagnon thinks that the persistence of high unemployment means the Fed should keep trying to drive down interest rates, despite the diminishing returns.

But this does point to the limits of the Fed's power. The lower interest rates go, the less the Fed can do.

This limit is why Ben Bernanke keeps talking about federal spending — which is controlled by Congress and the President and outside the Fed's control, but which may play a key role in the economic recovery

In a speech today, Bernanke said said the Fed does have more tools it could use. But he also said:

...There is ample room for debate about the appropriate size and role for the government in the longer term, but — in the absence of adequate demand from the private sector — a substantial fiscal consolidation in the shorter term could add to the headwinds facing economic growth and hiring.

Translation: It's fine for Congress and the President to argue over the long-term federal deficit. But if they cut spending too fast, or too soon, they could make the already weak economic recovery even weaker. And there's only so much the Fed can do about it.