- The Washington Times - Tuesday, December 16, 2008

The Federal Reserve slashed interest rates by three-quarters of a percentage point to near zero Tuesday afternoon in a 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 dramatic fall in inflation in announcing that it likely will keep interest rates at “exceptionally low levels” for “some time” as long as it takes to revive the economy.

The Fed’s move sparked a rally in stock and bond markets. The Dow Jones Industrial Average spurted 225 points higher after the announcement.

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.

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.

With short-term interest rates now near zero including the key federal funds rate charged on overnight loans between banks that is controlled by the Fed the central bank is in danger of running out of ammunition to further prop up the economy through what is expected to be another year of recession.

Economists say the Fed will have to rely more in the future on efforts to lower long-term interest rates on mortgages and business loans to aid the economy. The Fed does not directly control those rates, but already has made targeted moves to try to lower rates on mortgages and commercial paper in a parade of measures announced this fall.

The Fed said in its announcement that it will rely more on these measures to prop up the economy.

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

By some estimates, the Fed and Treasury have put in place a $8 trillion in extraordinary easing moves to cushion the fall of the economy and financial markets.

Economists say the Fed’s all-out efforts are called for 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.

Yet despite the drastic drop in inflation and interest rates, credit markets remain locked up, bank loans remain hard to get, and consumers have all but stopped buying in the worst consumer recession in decades. New construction starts on homes fell an astonishing 19 percent to a new all-time low last month, the Commerce Department reported Tuesday morning.

Mr. Bethune said he is not worried that the Fed is running out of ways to aid the economy.

“The Fed has plenty of ammunition available to bring down borrowing costs and restore the normal operation of credit markets,” he said. “The Fed will expand its balance sheet further to support the commercial paper, securitized debt, and mortgage debt markets, and work actively to bring rates and spreads down across the yield curve.”

By flooding the economy and financial markets with dollars, the Fed’s extraordinary moves do not come without a hitch, however. Many investors believe that the Fed’s actions, in combination with a federal budget deficit headed toward $1 trillion or higher this year, will spawn a renewed bout of inflation once the economy gets going again.

“The sharp sell-off in the U.S. dollar over the past couple of weeks appears to have been at least partly related to concerns over the rapid expansion of the Fed’s balance sheet,” said David Woo, analyst at Barclays Capital.

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