Saved by Zero? Fed Slashes Rate to Historic Low

Dec. 16, 2008 — -- In a bid to bolster the country's ailing economy, the Federal Reserve System is cutting its benchmark interest rate to its lowest level ever.

The Fed's Open Market Committee announced this afternoon that it is setting the target at a range from 0 to 0.25 percent. The move marks the first time the Fed has set a range instead of a single target.

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The historic decision was paired with pledges by the Fed to "employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability," including injecting more money into the lending markets.

The news drove a three-digit rally on Wall Street, with the Dow Jones industrial average spiking about 360 points.

In a statement explaining the Open Market Committee's decision, the Federal Reserve cited faltering economic conditions.

"Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further," the Fed said.

The statement stressed the other actions the Fed is taking to boost the economy, including buying mortgage-backed securities and other asset-backed securities.

"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 rate cut was greater than what many analysts had predicted. But the Fed's emphasis on its other tools -- lending and loan-buying programs -- echoed what economists had been saying before today's announcement: that the Fed's ability to set the key federal funds rate -- once the Fed's main instrument for shaping monetary policy -- is now overshadowed by its expanding lending powers.

"They've moved away from the period where it's the interest rate that matters to it's the size and the composition of the balance sheet that matters," said Vincent Reinhart, a former director of the Federal Reserve Board's division of monetary affairs and a resident scholar at the American Enterprise Institute.

The Federal Reserve's balance sheet has mushroomed to more than $2.2 trillion from just less than $900 million in early September. The surge reflects efforts by the Fed to inject money into frozen credit markets -- and ultimately encourage bank lending to businesses and consumers -- through a spate of new lending facilities.

These include a program to buy commercial paper, a type of corporate debt that can be used to finance day-to-day business operations, and a $600 billion program to buy new mortgage-backed securities and debt from mortgage giants Fannie Mae and Freddie Mac as well as two other government housing finance agencies.

"The Fed has moved to what they call quantitative easing policies, which is generally defined as anything other than [changing] the Federal Funds rate," said David Wyss, managing director and chief economist at Standard & Poor's. "They're seeing things locked up and therefore they're intervening."

But the Fed's injections, Wyss said, shouldn't last forever. Eventually, after Americans start spending money again, the Fed will have to "drain" its cash from the market to avoid inflation, he said.

Help for Mortgage, Home Equity Borrowers

There are signs that at least one Fed lending program is working.

Earlier this month, after the Fed announced the mortgage-buying program, interest rates on 30-year fixed mortgages fell below 5.5 percent from nearly 6 percent while rates on 15-year fixed mortgages dropped below 5.2 percent from nearly 5.8 percent. The declines prompted a spike in mortgage applications, according to the Mortgage Bankers Association.

The large-scale expansion of the Fed's lending program is what has pushed the actual interest rate for Fed reserves far below the benchmark rate of 1 percent, Reinhart said.

The target rate "is no longer the instrument of policy and hasn't been for the last month and a half," he said.

In a speech earlier this month, Federal Reserve chairman Ben Bernanke acknowledged that further rate cuts would have limited impact on the economy.

"Although further reductions from the current Federal Funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited," he said during a meeting of business leaders in Austin, Texas.

Nevertheless, the Fed rate cut will have at least some effect on American consumers.

Wyss said that, because home equity interest rates are tied to the Fed's benchmark rate, borrowers with home equity lines of credit stand to see their interest rates drop -- assuming, Wyss added, "your bank is still willing to give you one [or] you have some home equity to borrow against."

But Robert A. Brusca, the chief economist at Fact and Opinion Economics, said that the real reason the Fed will cut rates will be to prove "that it will do everything it can, absolutely everything, absolutely anything" to bolster the flagging economy.

Brusca, however, opposes another rate cut. He said that the cut would hurt those who depend on savings income -- interest rates on savings accounts rise and fall with the Federal Funds rate.

"I don't think you want to cut interest rates anymore," he said. "I think 1 percent is low enough. I don't think you get any more bang for the buck."

Help for Student Loans Next?

Brusca and Wyss agreed that the Fed should continue to expand its lending programs.

Wyss had a specific recommendation: that the Fed help ease the tight student loan market by buying securities backed by student debt.

"That's a scary one for the future for the country," he said. "If all these kids can't go to college because they can't get the student loans, what happens?"

With reports by ABC News' Daniel Arnall.