Wednesday, December 17, 2008

Fed Cuts Rates to a Record 0.25%

"The Fed will employ all available tools to promote the resumption of sustainable economic growth." — Federal Reserve

The Federal Reserve pulled out all the stops in its campaign to save the U.S. economy Tuesday, slashing interest rates to just above zero and promising to try an array of new economic measures to stimulate spending.

The central bank's Federal Open Market Committee established a target range for the federal funds rate of zero to 0.25%, effectively cutting its key rate for overnight lending to banks by between 0.75% and 1%. Rates will need to be kept low "for some time," the central bank said.

U.S. stocks leaped after the decision, with the Dow closing up 359 points (4.2%), the S&P 500 up 45 points (5.1%), and the NASDAQ up 82 points (5.4%).

A senior Fed official told reporters that the Fed has switched tactics and will now focus on aiding credit. The Fed has already targeted a few debt classes for assistance. The senior official said that other classes, including below triple-AAA quality debt, may be purchased.

The official said the program was not quantitative easing as practiced by Japan in the 1990s. While Japan simply wanted to increase the quantity of money, the Fed wants to focus on the asset side of the balance sheet.

The moves are just about as aggressive as the central bank could be on monetary policy. The Fed gave clear signals that it has moved on to other measures beyond setting interest rates in its fight to keep the economy rolling.

But the senior Fed official said that economists at the central bank generally are in agreement with Wall Street economists about the duration and depth of the recession. After two quarters of very weak growth, the economy should start a slow recovery after mid-year, the official said.

The Fed statement said that inflation should continue to moderate in coming months. The senior Fed official said that deflation, or a general price decline, was not a major risk at the moment, but that price data would be watched carefully.

"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth," the central bank pledged in its policy statement. Going into next year, the focus of the Fed's policy will be to support financial markets and stimulate the economy "through open market operations and other measures that sustain the size of the Fed's balance sheet at a high level."

In a speech on December 1, Fed Chairman Ben Bernanke said the central bank had a menu of measures from which to choose to lift the economy even if rates fell to near zero. "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," he said.

So the key will be the quantity of money in the system, not the price.

The Fed's balance sheet has risen to $2.25 trillion over the past two months from $850 billion and has made promises to spend about a $1 trillion more. The Fed is using the money to ease strains in the market for the debt of Fannie Mae and Freddie Mac and mortgage-backed securities issued by these GSEs.

These purchases may be expanded, the Fed said. "The FOMC is also evaluating the potential benefits of purchasing longer-term Treasury securities," the Fed said.

By February, the Fed is also going to begin buying credit card debt and student loans. This template could be expanded. Under this plan, the Treasury is assuming the risk of loss while the Fed is making the purchases. Economists applauded this laser-beam approach.

Adding "$100 billion here and $100 billion there strategically injected into the right places" can have a big impact, said Steve Stanley, chief economist at RBS Greenwich Capital.

Other markets are clearly on the Fed's radar screen.

"The Fed will continue to consider ways of using its balance sheet to further support credit markets and economic activity," the statement said. The senior official said that lower quality assets could be purchased.

The vote to lower the fed funds rate was unanimous.

Sources: The Federal Reserve, MarketWatch, Reuters

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