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THE ECONOMY

Fed may plumb fresh depths

The central bank is expected to cut its key rate to 0.5% or lower.

December 16, 2008|Maura Reynolds | Reynolds is a reporter in our Washington bureau.

WASHINGTON — When it comes to the Federal Reserve these days, one question dominates: How low will it go?

The central bank has already cut its benchmark rate to a measly 1%, but most economists think the Fed's rate-setting committee will take that down another notch or two when it ends a two-day meeting in Washington today.

The consensus bet is that the central bank will lower its benchmark rate to 0.5%, but a few economists say they wouldn't be surprised if the Fed takes it all the way down to 0.25%, which would be the lowest on record.

If it happens, the cut in the federal funds rate would be the latest in a series of steps by government regulators to thaw the near-frozen credit markets and slap some vigor into the moribund economy.

Banks will find it a little cheaper to lend money. And consumers with home equity loans and certain credit cards will also see lower interest rates, perhaps enticing them to spend some of the money they save on their debt payments.

On the downside, many savers will see lower interest payments on their deposits. And some economists worry that cutting the Fed's benchmark rate below 1% will put strains on money market mutual funds, making it harder for them to cover basic administrative costs.

Peter Kretzmer, chief U.S. economist at Bank of America, said concern had eased in recent weeks as the funds found new strategies to cope with the rare low-rate environment.

Indeed, any change in the target rate will have little practical effect, because the actual rate has been well below the 1% level for weeks. In fact, the average daily funds rate in November was 0.39%, according to Fed statistics.

Kretzmer said the effect of officially setting the target below 1% was mostly psychological, a signal that the Fed was committed to healing the financial markets and the rest of the economy.

"It's not as though what they announce tomorrow is going to affect the effective rate," Kretzmer said Monday. "What's going to matter is what they say in the statement."

The statement that accompanies the rate announcement usually gives Fed governors' view of the direction of the economy. But this month it's also expected to give investors and the rest of the public new insights into how the Fed operates.

Late last month, Fed governors announced that they would begin buying up some of the troubled securities that have been clogging the financial pipes since last summer, taking the securities onto their own balance sheet. Like lowering interest rates, that kind of direct purchase of securities expands money supply; economists have dubbed it "quantitative easing."

The Fed statement is expected to indicate that going forward, the central bank will concentrate more on quantitative easing than on interest rates.

"There really will be very little impact from the half-point cut," said David M. Jones, a former Fed economist and president of DMJ Economic Advisors. "What counts is what they have announced they would do in the unconventional realm."

On Nov. 25, the Fed announced that it would spend as much as $800 billion buying up the securities that fund consumer credit, including mortgages, student loans, auto loans and credit cards.

The Fed has made an initial purchase of $15 billion in mortgage securities issued by Fannie Mae and Freddie Mac and expects to buy $85 billion more in months to come. An additional $500 billion will be spent on privately issued mortgage securities and $200 billion on so-called asset-backed securities that fund student loans, auto loans and credit cards.

As soon as the Fed made the announcement, mortgage rates began to fall -- a sign, Jones said, that those purchases will do more to fix the financial markets than any of the Fed's other actions to date.

Fed Chairman Ben S. Bernanke indicated as much this month.

"Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver -- the provision of liquidity -- remains effective," Bernanke told business leaders in Austin, Texas.

In theory, the Fed's balance sheet is infinite and will permit the central bank to buy as many troubled assets as it thinks necessary.

"Bernanke is the only person who can create money out of thin air," Jones explained. "Any time he buys an asset, he writes a check and that becomes reserves for banks. Nobody can do that except the Fed. They can write a check, and that creates reserves and that creates money."

If all goes well, economists say, the Fed will eventually have to cut back the money supply before inflation takes hold. But the Labor Department is expected to confirm today that signs of inflation at the consumer level have all but disappeared.

At the same time, the overall health of the economy is still critical. The Fed released industrial production numbers Monday that showed a 0.6% drop in November, led by a 1.4% decline in manufacturing.

"The manufacturing sector is flat on its back," said Joel Naroff, president of Naroff Economic Advisors in Holland, Pa. "It didn't matter whether it was consumer goods or business products -- output fell. Over the past year manufacturing production has dropped over 7%, a huge decline that clearly shows the extreme nature of the downturn."

Bernanke has clearly indicated that the Fed has put inflation concerns on the back burner for now.

"To avoid inflation in the long run and to allow short-term interest rates ultimately to return to normal levels, the Fed's balance sheet will eventually have to be brought back to a more sustainable level," Bernanke said in Austin. "However, that is an issue for the future; for now, the goal of policy must be to support financial markets and the economy."

--

maura.reynolds@latimes.com

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