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Fed cuts its rate to zero -- and it's not done yet

Its plans to help revive the economy include injecting cash through new loans and buying and selling securities.

December 17, 2008|Maura Reynolds

WASHINGTON — The U.S. Federal Reserve ushered in a new era Tuesday: For the foreseeable future, interest rates are nearly meaningless as a tool of economic policy.

The central bank took two bold steps. First, it lowered its benchmark interest rate to as low as zero for the first time in half a century. Second, it strengthened its pledge to buy vast amounts of mortgage-backed debt and possibly other securities to spur lending and help restore the economy to health.

"By going to zero, the [Fed] recognized that interest rate actions are now over and the members will be concentrating on other means to increase growth," said Joel Naroff, president of Naroff Economic Advisors, an economic forecasting firm in Holland, Pa. "What the Fed intends to do is be, in essence, the invisible hand in all financial markets."

The moves were far more aggressive than markets had been expecting, and stocks rallied, with the Dow Jones industrial average soaring nearly 360 points.

"This is the next set of tools that the Fed can take out of its tool bag," said Bart van Ark, chief economist of the Conference Board, a business research group. "Interest rates are a more subtle instrument. . . . What we're going to get now are more radical, rougher tools. But they'll probably help."

In normal times, the central bank manages the economy by adjusting interest rates: Lower rates spur people to borrow money to expand businesses, buy goods and build homes -- thus fueling economic activity. Higher rates rein it in.

But these are not normal times, and the interest rate mechanism hasn't been working well for months. One sign has been that even as the Fed has repeatedly lowered its benchmark rate, banks have remained fearful of more economic trouble to come and have been reluctant to lend to one another and to consumers.

Now the Fed plans to focus on buying mortgage-backed securities and other debt. The Fed had already announced a plan to buy $600 billion of such assets, and it said it hoped the program would get underway in earnest shortly.

On Tuesday, the Fed said it was considering doing the same with longer-term Treasury bonds -- a move that might also help lower rates on mortgages and other consumer loans not linked to the benchmark rate.

"This is exactly the kind of forceful medicine the economy needs as it plumbs the depths of the current recession," said Brian Bethune, chief U.S. financial economist for IHS Global Insight, an economic forecasting firm in Lexington, Mass. "The Fed's actions will translate into much lower effective borrowing costs in the next few weeks, with the prime rate dropping immediately to 3.25% and mortgage rates moving down towards the 5% range within a few weeks."

Fed officials said they were taking the actions because of the extraordinarily dismal condition of the economy.

"Labor-market conditions have deteriorated, and the available data indicate that consumer spending, business investment and industrial production have declined," the Fed's rate-setting committee said. "Overall, the outlook for economic activity has weakened further."

Fed governors said they anticipated "that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."

Since the 1990s, the Fed has set a target for its benchmark federal funds rate -- the rate banks charge one another for overnight loans to shore up their reserves. Though the target rate has been at 1% since Oct. 29, the actual rate has been much lower for weeks; it averaged 0.39% in November.

Fed governors said the new target would be a range: from zero to 0.25%. A senior Fed official said that for practical reasons, it would be extremely difficult for the central bank to hold the rate at zero, which is why officials decided to establish a range.

It was the first time since the current interest rate system began in the 1990s that the target was set below 1%. Actual interest rates have fallen below 1% only a few times since the Fed was founded in 1913.

Fed Chairman Ben S. Bernanke has been laying the groundwork for near-zero interest rates for months, developing and implementing ways of injecting cash into the economy by making loans in novel ways and buying and selling a wide range of securities on the open market.

The Fed's balance sheet has more than doubled as a result, expanding from about $900 billion a year ago to more than $2.2 trillion now. Fed officials indicated Tuesday that they were prepared to allow the balance sheet to grow as much as needed to get the economy through the crisis.

"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 said in a speech this month.

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