Captain Zero, our next hero, might need help saving us

IS THE FED running out of ammo?

The central bank's main weapon against recession is the short-term interest rate, which it has brandished lately like a Kentucky rifle at the Alamo.

The overnight federal funds rate, a benchmark that is also the Fed's main lever for moving short-term rates generally, has plunged from 6.5 percent to 1.25 percent since January 2001.

The Fed has cut rates a dozen times in less than two years. The latest move, a month ago, was a surprising, aggressive reduction of half a percentage point to the lowest level for the overnight funds rate since July 1961.

Lower rates are supposed to spur borrowing and spending by making loans less expensive. And, indeed, zero percent car loans and 6 percent mortgages have helped keep consumers shopping even as other parts of the economy have frozen up.

But overall economic activity has not rebounded the way policy-makers had hoped, and some are starting to worry that Fed Chairman Alan Greenspan is down to his last couple of bullets.

After all, the Fed can't cut rates below zero. It has moved rates four-fifths of the way toward zero. If that won't fire up the economy, what will?

Some fear that the United States could do a Japan, slumping into years of torpor and deflation that become unresponsive to even the lowest interest rates.

Deflation, associated with weak economies and defined as widespread and persistent falling prices, is dangerous because it cuts into company profits and, once established, can feed on itself.

Expecting prices to fall, people delay buying cars, furniture, houses and so forth. That dampens economic activity and prompts businesses to reduce prices even more to try to move the goods, which further hurts profits, which causes layoffs, which weakens demand some more. Few economists are predicting such a course for the United States over a sustained period. This country's flexible labor markets and decent bankruptcy system should allow economic regeneration before too long, many analysts believe.

But the Fed is getting worried. Deflation and depression are examples of "tipping point" phenomena that, once over the edge, become self-fulfilling. If consumers believe slump and deflation loom, they will behave in ways that make slump and deflation inevitable.

To try to avoid such an outcome, the Fed has embarked on an extraordinary jawboning campaign to convince us that it is still in control. Deflation "is really not much of a threat for the U.S.," Fed Governor Ben S. Bernanke said on CNBC a few days ago. "And moreover, if it were to happen, the Fed does have the tools to deal with it."

This is Fed trash talk, calculated to make deflation stop, think and run back to Japan.

"Our conclusion is that we are not close to a deflationary cliff," Greenspan told Congress two weeks ago.

But just in case, the Fed is signaling that it has novel and unusual ways of dealing with deflation, that it has not yet begun to fight.

As noted, short-term rates have traditionally been the focus of the Fed's monetary tinkering. To lower short rates, the Fed buys Treasury debt, which injects money into the economy, which increases the money supply, which makes the price of money - interest - less expensive.

But long-term rates, which tend to be higher than short rates, are harder for the Fed to influence.

Long rates depend not just on the money supply but on what lenders think will happen to the economy and borrowers years hence.

Some analysts believe that the economy has been hindered because long rates have not fallen as sharply as short ones.

Now the Fed is talking about aiming at long-term rates directly, if it must, by buying huge quantities of longer-term Treasury securities. This would raise the price of the notes, lower their rates and, policy-makers would hope, reduce other long rates. Bernanke has suggested other moves the Fed could make if zero percent short-term rates don't cure the economy. The central bank could buy bonds of foreign governments or U.S. agencies such as Ginnie Mae, injecting further liquidity, he said.

It could make zero percent loans to banks through the Fed's "discount window." Or it could try to reassure markets by promising to keep short rates low for a lengthy period, he said.

Of course, all the talk about secret anti-deflation weapons is itself an anti-deflation tactic, intended to reassure Americans that Greenspan hasn't lost it.

Let's hope the chatter is more than bravado. But let's also hope the economy doesn't put it to the test.