- The Washington Times - Tuesday, December 16, 2008

UPDATED:

The Federal Reserve slashed interest rates by three-quarters of a percentage point to nearly zero Tuesday in its latest strenuous attempt to revive the economy from the deepest recession in a generation.

The dramatic rate cut followed a record 1.7 percent drop in consumer prices reported by the Labor Department, offering further signs that the economy’s steep fall is posing a danger of deflation that the Fed must fight to keep the recession from worsening.

The Fed noted the “deteriorating” economy and rapid fall in inflation in announcing that it intends to keep interest rates at “exceptionally low levels” just above zero for an extended time — as long as it takes to return the economy to growth, according to a senior Fed official.

With rates now as low as they can go, it will be the last rate cut possibly for years, the official said, but the Fed is preparing other measures to resuscitate the economy from what many economists predict could be another year of recession. The Fed’s move sparked a major rally in stock and bond markets. The Dow Jones Industrial Average surged 361 points to 8,925 as investors took solace in the Fed’s largesse.

Even before the Fed’s actions, market interest rates dropped dramatically on the unexpectedly large fall in consumer prices, which for the second month was spawned by huge drops in the prices for oil, gasoline, wheat and other commodities. The news prompted yields on 30-year Treasury bonds to fall to a record low of 2.94 percent. After the Fed’s move, bond rates moved still lower to 2.83 percent.

The Treasury for weeks has been paying interest rates near zero on its T-bills as investors all over the world flocked to safe-haven government securities to escape imploding stock and commodity markets.

The Fed’s action brought the rates on key short-term loans to banks that are controlled by the Fed to between zero and 0.25 percent, bringing an effective end to the Fed’s use of those rate tools to aid the economy. With many commentators fretting that the Fed has now “run out of ammunition” to respond to the recession, the central bank took extraordinary care to detail Tuesday to reporters how it can further aid borrowers and the economy through alternative means.

The Fed official said the central bank in the future will try to help lower the rates that consumers and businesses actually pay on their loans — which often is far above the rates set by the the Fed and Treasury market because lenders build in “premiums” for risk and liquidity that reflect their worries about people and firms going into default and bankruptcy. Mortgage rates and credit card rates, for example, remained elevated despite the Fed’s efforts this fall — reflecting the heightened rates of default. Some kinds of mortgages, such as subprime and exotic loans that fueled the credit bubble earlier this decade, are not available at all anymore.

Even before Tuesday’s action the Fed moved to try to lower 30-year mortgage rates by announcing a program to purchase as much as $500 billion of mortgage-backed securities — producing an immediate drop in conventional mortgage rates early this month. The Fed also has achieved substantial reductions in the rates on commercial paper, or short-term business loans, under a program begun this fall.

The Fed official said the central bank will launch further such efforts to lower market interest rates working jointly with the Treasury Department, as it did in the previous program.

“The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” the Fed’s rate-setting committee said in a statement Tuesday after a two-day meeting.

The new approach the Fed is planning promises to expand considerably the Fed’s balance sheet, which already has grown to $2.2 trillion as a result of previous actions, the Fed official said.

Economists say the Fed’s all-out efforts are appropriate as the economy faces its severest test in modern times.

“In the space of only three months, yearly inflation is expected to drop to near zero percent” after running near a 6 percent rate this summer — in itself, an unprecedented development, said Brian Bethune, chief U.S. financial economist at IHS Global Insight.

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