“With the Federal Reserve apparently ready to cut interest rates next week, officials indicated Thursday that a quarter-point cut remains firmly on the table, despite the market expectation of a half-point cut,” writes Grep Ip in today’s Wall Street Journal.

“Fed officials emphasized they haven’t decided how far to move rates next week and are keeping all their options open. But beyond that next rate cut, the Fed now faces a daunting challenge: How to continue to ward off potential deflation when short-term interest rates are closer to zero than they have been in 45 years.”

“Several months ago, officials said that in such a near-zero scenario the Fed could keep rates down by buying Treasury bonds, as it did in the 1940s. Such a buying spree would raise bond prices and lower their interest yields, which move in the opposite direction. But after months of study, Fed officials have concluded that today’s far-more-complex bond market would frustrate that strategy.”

“The Fed’s key rate already is at 1.25%. After next week’s move, cutting it even closer to zero will pose problems. Too low a rate would imperil money-market mutual funds, for instance, because they might no longer clear enough money to cover expenses and pay a return to investors. It would leave the impression the Fed was out of rate-cutting ammunition. And a zero rate could disrupt the market in which Treasury bills, commercial paper and bank deposits trade. Why would a bank borrow in the money market when the Fed is providing ample funds free of charge?”

“So Fed officials are concluding the best alternative tool for boosting growth is persuading investors — through careful communication — about its intentions on short-term rates. It must convince investors that rates will remain low long enough to extinguish fears of deflation and ensure that economic expansion is well entrenched. Deflation is dangerous because falling prices often lead to falling wages, making it hard for companies and households to pay back debts. While the Fed can raise interest rates as high as it wants to fight inflation, it can’t cut them below zero to fight deflation.”

“The Fed already has had surprising, if unexpected, success in sending such messages to investors. After their May 6 meeting, Fed officials declared lower inflation to be a bigger risk than higher inflation. From that, investors concluded the Fed would keep rates low much longer than had been thought, and drove bond yields down. Long-term rates — 10 or more years — are more than half a percentage point lower than they were before the Fed statement, even after rising in the last few days. The low rates gave mortgage refinancing and the rest of the economy a boost even though the Fed hadn’t touched its short-term federal-funds rate, which is charged on overnight loans between banks.”

“Financial markets Thursday were betting that the Fed will cut the Federal funds rate by half a percentage point this coming Wednesday. But Fed officials are uncomfortable with that expectation because the Fed hasn’t decided the size of any rate cut and doesn’t want to shock the markets.”

“Fed Chairman Alan Greenspan recently said that while the risk of deflation is small, it was a dangerous-enough outcome that it was worth taking out insurance to keep the risk small. To back up his rhetoric and keep bond yields at their new lower levels, Mr. Greenspan will likely recommend a rate cut next week, the first cut since November.”