Dec. 17 (Bloomberg) -- Back in November 2002, when Ben Bernanke was a Federal Reserve governor and the U.S. economy was facing a faux deflation crisis, he gave a speech entitled, “Deflation: Making Sure ‘It’ Doesn’t Happen Here.”

He probably had no idea that six years later, now in the role of Fed chairman, he’d be fighting the deflation demon for real, with everything he’s got.

In a bold move yesterday, the Fed lowered the target for its overnight benchmark rate from 1 percent to a range of 0 percent to .25 percent. The effective funds rate has been below the target for two months, in part because Fannie Mae and Freddie Mac can’t earn interest on the reserves they hold in excess of what’s required by the Fed.

For all those who like to compare slight word variations in the current and previous statements in the hope of divining future Fed policy, yesterday’s announcement departed from the usual boilerplate.

Specifically the Fed pledged to “employ all available tools” to rekindle economic growth and ward off deflation; to sustain its already bloated balance sheet “at a high level;” to purchase “large quantities of agency debt and mortgage-backed securities” to support the housing and mortgage markets; and to maintain “exceptionally low levels of the federal funds rate for some time.”

“They are throwing the book at it,” says Jim Glassman, senior economist at JPMorgan Chase & Co. “There is no end to the options the Fed can use.”

Promise Made

Banks can now borrow at an interest rate of virtually zero, secure in the knowledge that the Fed isn’t going to raise the funds rate anytime soon. Policy makers expect economic conditions to “warrant exceptionally low levels” for some time.

Katy bar the door when things change. The Fed’s balance sheet has ballooned 155 percent in the past year, most of it in the last three months. When confidence and the willingness to take risk return, the Fed will have to demonstrate the same agility it has shown during the crisis and drain the $590 billion of excess reserves banks now hold. (Prior to the credit crisis, banks held an average of $1 billion to $2 billion of excess reserves.) It’s these reserves that have the potential to multiply into money.

A promise made by the Fed to hold overnight rates at close to zero is a promise kept only if inflation expectations stay muted.

Before the Fed’s balance sheet shrinks, however, it’s going to get a lot bigger.

‘Buy It All’

“There’s a saying in regard to legal contracts: If you write at all, write it all,” says Paul Kasriel, director of economic research at the Northern Trust Co. “Well, the Fed has finally decided if it is going to buy at all, it will buy it all.”

The Fed previously announced its intention to purchase “large quantities” of agency debt -- bonds issue by Fannie and Freddie, for example -- as well as mortgage-backed securities, and has bought $8 billion of agencies so far this month. And Bernanke already introduced the possibility of buying longer-term Treasuries, an idea reiterated in yesterday’s statement.

It’s hard to see what the benefit of lower long-term Treasury yields would be. Yields on the 5-, 10- and 30-year Treasuries are already at record lows of 1.29 percent, 2.27 percent and 2.75 percent, respectively.

“The Fed gets hung up on Treasuries,” Kasriel says. “It’s not the term structure of the risk-free curve that’s high. It’s the spread between private lending rates and Treasury rates that’s high.”

Go the Distance

If private lending rates are what need to come down, the Fed can have a much bigger impact if it buys direct.

Besides, lower long-term Treasury yields could even be counterproductive. A steeper risk-free curve is better for banks, providing an inducement and a means to bolster profits.

With the Fed effectively guaranteeing a fixed, low funding rate for the “foreseeable future,” to borrow a phrase from Alan Greenspan, banks can borrow from the Fed and buy intermediate and long-term Treasuries. The profit goes to their bottom line. The act of lending -- the U.S. government has a huge demand for credit even if no one else does -- increases the money supply. Growth in the money supply is an antidote to deflation.

The steep yield curve rescued the banks following the savings and loan crisis in the early 1990s. It will provide solace and succor this time, too -- eventually.

It is to hasten that eventuality that the Fed is pulling out all the stops.

(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net

Last Updated: December 17, 2008 00:01 EST