Fed cuts its rate to zero -- and it’s not done yet
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.
Over time, very low interest rates can fuel inflation. For much of last year, as prices for oil and other commodities soared, the Fed expressed concern that lowering rates could drive prices for goods and services higher.
But gasoline prices have fallen off a cliff since July, and the consumer price index is declining at a record pace as a result. The Labor Department reported Tuesday that inflation at the consumer level fell 1.7% for November, largely because of a 17% drop in energy prices.
Because of the volatility of energy and food prices, the Fed tends to pay attention mostly to the “core” inflation rate, which excludes those prices. The core rate stayed flat in November, the Labor Department reported, and is up just 2% over the last 12 months -- within the Fed’s target of 1% to 2%. That cleared the way for Tuesday’s rate cut.
“Inflationary pressures have diminished appreciably,” the Fed’s rate-setting committee said, adding that it expected “inflation to moderate further in coming quarters.”
The decline in gasoline prices is a bright spot for consumers in an otherwise gloomy economic landscape. According to AAA, the U.S. average price for a gallon of regular gasoline is now $1.66, down from about $3 in early October and an all-time high of $4.17 in July.
“While households may not go out and party with the money, they do seem to be using it to clean up the mess on their balance sheets,” Naroff said. “When the rebound hits, households should be better prepared to start spending again.”
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Times staff writer Jim Puzzanghera contributed to this report.
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What the Fed’s action means for consumers
SAVERS
Yields on bank certificates of deposit and money-market mutual funds will probably continue falling.
MORTGAGES
The Federal Reserve’s purchase of mortgage bonds may further push down the costs of fixed-rate loans.
HOME EQUITY
Lines of credit tied to the prime rate will get cheaper. Banks have cut the prime rate to 3.25% from 4%.
OTHER LOANS
Some rates on credit cards and other consumer loans tied to the prime rate will decline.
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Fed’s rationale for rate cut
Here is the statement issued Tuesday by the Federal Reserve:
The Federal Open Market Committee decided today to establish a target range for the federal funds rate of zero to 0.25%.
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.
Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the committee expects inflation to moderate further in coming quarters.
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. 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 focus of the committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.
In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 0.5%. In taking this action, the board approved the requests submitted by the boards of directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco. The board also established interest rates on required and excess reserve balances of 0.25%.
