Fed cuts interest rates to near zero to combat economic recession

BySue Kirchhoff, USA TODAY
December 16, 2008, 3:48 PM

WASHINGTON -- The Federal Reserve Tuesday cut its target for a key short-term interest rate to a record low range of zero to 0.25%, from the previous 1%, and vowed to maintain "exceptionally low rates" for "some time".

The dramatic move sent stocks soaring as the Dow Jones industrial average surged 4.2% and broader indexes jumped more than 5% after the central bank said it would accelerate its use of nonconventional tools to stimulate the economy, like buying mortgage-backed securities or Treasury notes.

In a statement announcing its actions, the central bank's policymaking Federal Open Market Committee, which was unanimous in its decision, said the job market, business and consumer spending and manufacturing had all weakened since its Oct. 29 meeting, while inflation pressures "diminished appreciably. It promised to do whatever it takes to support the economy.

"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability," the Fed said. "In particular, the committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."

The Dow rose 359.61 to 8,924.14 after having been up about 100 in subdued trading ahead of the Fed's announcement.Broader stock indicators also rose. The Standard & Poor's 500 index advanced 44.61, or 5.14%, to 913.18, and the Nasdaq composite index rose 81.55, or 5.41%, to 1,589.89.

"All in all, it's good news for stocks," said Jack Ablin, chief investment officer at Harris Private Bank. "It gave the market a little bit more than they expected."

The Fed said it is evaluating the potential benefits of buying longer-term Treasury securities, which would bring down interest rates on those instruments.

The federal funds rate is what banks charge each other for overnight loans. The funds rate, the central bank's preferred policy tool in recent years, is a benchmark for many consumer and business loans.

"So here we are: Rock bottom," said Ian Shepherdson, chief U.S. economist for High Frequency Economics, who called the Fed move "a reflection of an utterly desolate economic picture, which will persist for the foreseeable future as the wrenching adjustment in household finances continues."

"If zero rates don't work, they will try anything; good. But this is a terrible, chastening day," Sheperdson said.

In some ways, today's rate cut merely acknowledges current conditions, since the federal funds rate has been trending well below the Fed's 1% target on credit markets for weeks. In the past week, for instance, the federal rate fell as low as 0.14%.

The Fed's difficulty in managing the rate may be one reason the Fed, for the first time, gave a range for its rate target.

But the overall Fed actions underscore its willingness to employ a range of dramatic and trendsetting steps to aid the economy. By promising to keep the federal funds rate low for as long as needed, the Fed is trying to provide certainty to investors.

"They are pulling out all stops ...saying that low rates are here to stay for some time. By doing this they jawbone the long-end of the yield curve lower, and lower long-term rates will help bring down the cost of borrowing for corporations, helping them to fund long-term projects, add to working capital, and pave the way for future economic growth," said Chris Rupkey of the Bank of Tokyo-Mitsubishi.

"The economy must be in pretty bad shape if the Fed needs to jump market expectations and push rates just a hair above the zero line," Rupkey said.

The central bank is also signaling it has plenty of tools available, even with rates at zero. The Fed, which has already increased the size of its own balance sheet from $800 billion to more than $2 trillion, promised it would maintain its balance sheet at a high level.

"The focus of the (Fed's) policy going forward will be to support the functioning of financial markets and stimulate the economy through ... measures that sustain the size of the Federal Reserve's balance sheet at a high level," the central bank said.

The Fed reiterated its earlier announcement that it will purchase up to $500 billion in Fannie Mae and Freddie Mac mortgage-backed securities and "stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. Mortgage rates have already fallen since the Fed announced the move several weeks ago. The Fed has also announced it will set up special programs to backstop credit cards and student and auto loans.

"The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity," the Fed said.

The Fed's action came as the government released new data showing the worst housing market in decades and a second record-setting monthly decline in consumer inflation.

The Census Bureau said housing starts fell 19% in November — the biggest one month drop since 1981. Building permits, an indicator of future housing activity, also tumbled and are down 48% from year-ago levels. Overall, new home construction is at the lowest level since the government began keeping statistics in 1959.

The government also said the consumer price index, which measures retail inflation, fell by a record 1.7% in November, due mainly to a steep drop in energy prices. Since peaking in July at a 5.5% annual rate, consumer inflation has plummeted to a 1% pace — falling at a 10% annual rate during the past three months. The three-month drop is the largest since the government developed its seasonally adjusted measurement system in 1947.

Energy prices fell 17% during November, with gasoline prices down nearly 30% from October. While price decreases were widespread, food prices continued to rise, though at a much slower pace. Food and beverage prices rose 0.2% in November, and are up 6.9% from year-ago levels.

The falling prices give the Fed more room to cut rates. In fact, the sharp decline is likely to increase concerns within the central bank about the possibility of deflation — a widespread, sustained decline in prices that can hurt the economy. Concern about deflation also make it more likely that the Fed will turn increasingly to so-called quantitative easing — trying to bolster the economy by increasing the amount of money in circulation.

While the Fed in its statement said it had plenty of options left, Fed Chairman Ben Bernanke has made it clear the central bank can't solve the problems besetting the economy by itself. Bernanke early on threw his support behind congressional efforts to pass a significant economic stimulus package that could include public works spending on roads and schools, aid to states, expanded health care benefits and other measures.

President-elect Barack Obama underscored the urgency of stimulus spending at a news conference in Chicago Tuesday, during which he said the nation was "going through the toughest time economically since the Great Depression."

"I don't think it's good policy for the president and president-elect to second-guess the Fed, which is an independent body," Obama said, in response to a question about central bank policy. "We are running out of the traditional ammunition that's used in a recession, which is lower interest rates. Although the Fed is still going to have more tools ... it is critical that the other branches of government step up."

Obama, who met with his economic advisers Tuesday, reiterated that he would push Congress to quickly push a economic stimulus plan to meet short-term needs, and position the U.S. economy for sustained growth over the longer term.