NEW YORK, Nov 22: It’s a dilemma most central banks would rather avoid but the Federal Reserve is being forced to confront: the risky business of pushing interest rates all the way to zero.

The dreaded zero mark lends a scary, skittish quality to the conduct of monetary policy. Ordinarily, policy-makers rely on lowering rates to promote growth. Yet with borrowing costs at the bare-bones of one per cent, a half-point cut would amount to half the US central bank’s ammunition.

That is not to say the Fed will run out of tools to influence the economy if it decides it needs to press rates to zero, and if the latest news of declining prices turns into a more pronounced deflationary trend.

Possible further steps include a commitment to keeping rates low for a prolonged period of time, or a broader expansion of the assets the central bank accepts as collateral for loans.

But the Fed would be operating in largely uncharted territory, with much more uncertainty than stability-seeking central bankers are generally comfortable with.

“Some of these alternative policy tools are relatively unfamiliar,” said Russell Jones, global head of fixed-income research at RBC Capital Markets. “They may raise practical problems of implementation and calibration of their likely economic effects.”

The Fed appears well aware of these pitfalls. Minutes from its last meeting in October pointed to a policy-setting committee made less concerned with inflation by a worsening economy, but one that also felt some nervousness regarding the potential need to bring official rates down to zero.

“If resource utilisation remained weak for some time, inflation could fall below levels consistent with the Federal Reserve’s dual mandate for promoting price stability and maximum employment,” the minutes said, an allusion to the possibility of mounting deflation risks.

Such a development “would pose important policy challenges in light of the already-low level of the committee’s federal funds rate target,” the Fed said.

Still, the central bank signalled it was willing to cut rates further to stop what has become an accelerating raft of bad news, including steep job cuts and a grim outlook for lending, and financial markets expect a half-point cut when the central bank meets in mid-December.

One worry is that money market funds, which already came under pressure when the Fed’s abundant liquidity measures pushed the effective fed funds rate to zero in the markets, could see shares once again break below $1.

“I’m of the view that if they cut, it’s going to be another 50 basis points and then they’ll stop,” said Anna Piretti, economist at BNP Paribas. “Otherwise everybody would just start pulling out of money market funds and that would create a lot of systemic issues.”

Others, however, believe the Fed would not sacrifice the wider economy to spare money markets, and note the central bank and US Treasury have already taken steps to support the sector.

“We do not think this cost is enough to constrain the Fed, in part because facilities such as the Money Market Investor Funding Facility should help to provide a more orderly transition for this market,” said Michael Feroli, an economist at JPMorgan.

Indeed, the Fed has good reason to act aggressively if it sees a deflation threat. When prices fall, inflation-adjusted rates rise even if nominal borrowing costs are held steady -- and that can further undercut growth and worsen the deflation.—Reuters