Countries Move to Stimulate Economy

Feds make emergency rate cut to 1.5 percent, Britan cutsw

October 6, 2008, 6:21 PM

Oct. 8, 2008 — -- Trying to stop a meltdown in global markets, the Federal Reserve along with the Bank of Canada, the Bank of England, the European Central Bank, Sveriges Riksbank, and the Swiss National Bank announced a coordinated reduction in interest rates.

The Fed dropped its key federal funds rate from 2% - which it has held there for some time – by 0.5% percent. The Fed Chairman Ben Bernanke as much as telegraphed this cut could happen – though perhaps not THIS soon – yesterday when he spoke in Washington and said US "economic growth has worsened."

Investors and market analysts around the globe have talked about the need for greater coordination among central banks to combat what has now become a global problem.

European stocks are bouncing from lows after the news. US futures are up as well.

The United States, Spain and Australia took action Tuesday also aimed at stimulating the slowing world economy.

In Washington, the Federal Reserve announced it was starting an ambitious program to buy up to $99 billion worth of unsecured short-term debt, using a little known federal instrument that dates to the Great Depression of the 1930s.

The so-called commercial paper market is the method many businesses rely on to fund day-to-day operations.

The Fed announced in a statement that the creation of the Commercial Paper Funding Facility, which will complement the Federal Reserve's existing credit methods of providing liquidity to term-funding markets.

In Madrid, Prime Minister Jose Luis Rodriguez Zapatero announced Tuesday that Spain is setting aside up to $41 billion to help the financial sector, and said the government would also increase the deposit insurance for citizens to $136 billion per account, a twofold increase.

Australia took action too, announcing it was lowering its key interest rate from 7 percent to 6 percent, the biggest reduction in more than seven years.

In a statement announcing the cut, the governor of the Reserve Bank of Australia attributed the bank's decision in part to the "the recent deterioration in prospects for global growth, together with much more difficult market conditions even for credit-worthy borrowers."

While the various actions helped shore up the markets, they fall short of a more coordinated interest rate intervention that some have called for.

The United States has already taken an aggressive approach on the interest rate front, with the Federal Reserve and its Chairman Ben Bernanke cutting its key interest rate from 5.25 percent in September 2007 to 2 percent now.

Other nations have not been as keen to lower their rates. But until now, their economies have weathered the financial crisis better than the United States.

The European Central Bank has held its key short-term rate steady at 4.25 percent. Its last decision to leave the rate unchanged came Oct. 2 at its regular monthly meeting.

Other banks also have rates higher than the United States. The Bank of England is currently at 5 percent and the Bank of Canada is at 3 percent.

Lower interest rates are generally a stimulus for the economy because they make the cost of capital cheaper, encouraging businesses to expand and invest. However, in the current financial crisis, interest rates have not been the issue -- no one is willing to lend due to a lack of confidence that they will be repaid.

The Fed and European Central Bank worked together to cut rates after the Sept. 11, 2001, terrorist attacks. Such acts are highly unusual, and it would be more so if several nations worked together at once.

England and the European Central Bank are both expected to make cuts but other countries may be more reluctant.

The Bank of Japan already has its key interest rate at 0.5 percent. The central bank confirmed today, as expected, that it would leave the interestrate unchanged. Given that country's 2 percent inflation rate, the rate is essentiality negative.

David R. Kotok, co-founder and chief investment officer of Cumberland Advisors, said such cooperation "will send some psychological message."

"It really is not needed," Kotok wrote in an e-mail. But "each of them will cut anyway, so we will see serial cuts in close proximity."

Mike Ryan, head of wealth management research, Americas at UBS, said that the United States and other countries, so far, have taken a "parochial approach" to addressing the financial crisis by addressing it on a "local level."

"The approach is an almost exclusively done, on a country by country, event by event basis," he said.

Ryan said that, instead, the G8 countries should be working together to address the financial crisis with a "global approach."

That should include, he said, but not be limited to a coordinated effort to cut rates by the different central banks, including the European Central Bank, which has yet to cut rates recently because of inflation concerns.

"We are hopeful that what we'll start to see is some measures put in place that will send some signals that global policymakers are going to work in tandem," Ryan said.

Gerald P. O'Driscoll Jr., a former vice president of the Federal Reserve Bank of Dallas and Citigroup, also questioned the need by some countries to make a cut.

"What are the Japanese going to do? I guess they can go back to zero, which they are very reluctant to do," O'Driscoll said. "The Europeans have the most scope for cutting."

While the U.S. Federal Reserve has its main rate at 2 percent, O'Driscoll said in recent days the Fed has put so much cash into the banking system that it has essentially already pushed rates lower in the marketplace.

"I guess they could cut, but they have. It would just be acknowledging what they have already done," he said. "Then, what happens if it doesn't work?"

"Then he's stuck," O'Driscoll added. "Then everybody knows the next thing he has to do is pull a Japan and go to zero."

A rate cut is probably not going to calm the markets, he believes. The problem is that many firms are deemed risky because they borrowed too much money to finance their investments. The only cure for that is to deleverage those investments.

"It's ugly, but it's not susceptible directly to central bank action," O'Driscoll said. "Would it do a great deal of harm? Probably not. Would it do a great deal of good? Probably not unless it turned out to be the magic bullet that restored confidence, and so far, nothing that either central banks or governments have been doing is restoring confidence.

"Maybe because part of it, that they just keep switching plans and coming up with new plans. After you do that several times, and I'm especially thinking of [Treasury Secretary Henry] Paulson, less maybe the Fed, people begin to say, 'Does this person know what they are doing? Or do they have a plan?'"

With reports by ABC News' Alice Gomstyn and The Associated Press.

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