- The Washington Times - Wednesday, December 17, 2008

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.

With rates now as low as they can go, it will be the last rate cut for possibly years, said a senior Fed official, but the Fed is preparing other measures to resuscitate the economy from what many analysts predict will be another year of recession.

Fed watchers said the central bank’s venture into new realms to try to keep stimulating the economy under Chairman Ben S. Bernanke is a revolutionary development in the history of the central bank.

The dramatic rate cut followed reports of a record 1.7 percent drop in consumer prices and an all-time low in housing construction last month, 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, the Fed official said.

The Fed’s move sparked a major rally in stock and bond markets. The Dow Jones Industrial Average surged 359.6 points to 8,924 as investors took solace in the Fed’s largesse despite the steady drumbeat of signs pointing to a worsening recession. Even before the Fed’s announcement, the huge drop in inflation, spawned by falling oil and commodity prices, had prompted yields on 30-year Treasury bonds to plummet to record lows below 3 percent.

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 to an end the Fed’s use of those rate tools to aid the economy. Despite the drastically lower inflation and interest rates, many credit markets remain locked up, bank loans are hard to obtain, and consumers have closed their wallets in the worst consumer recession in decades.

Commentators are fretting that the Fed is now out of ways to respond to the recession. President-elect Barack Obama addressed that worry during a news conference Tuesday.

“We are running out of the traditional ammunition that’s used in a recession, which is to lower interest rates. They’re getting about as low as they can go,” he said. “And although the Fed is still going to have more tools available to it, it is critical that the other branches of government step up, and that’s why the economic recovery plan is so absolutely critical.”

The senior Fed official said the central bank expects to get some help next year from the Obama administration’s economic stimulus program, which will focus on creating jobs by building roads, bridges and new energy infrastructure. But the central bank, in a conference call Tuesday with a few reporters, took extraordinary care to provide details about its own plans to further aid borrowers and the economy.

The Fed official said the central bank will try to help lower the rates that consumers and businesses pay on their loans - which often is far above the rates set by the Fed and Treasury market. Lenders build in “premiums” above the government rates to reflect risks, illiquidity and worries about default or bankruptcy.

Mortgage rates and credit card rates, for example, remained elevated despite the Fed’s efforts this fall and the Treasury’s takeover of Fannie Mae and Freddie Mac - 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 anymore.

In a preview of the Fed’s new approach, the central bank moved earlier this month 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 to about 5.5 percent. 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 make further efforts to lower market interest rates by working jointly with the Treasury as it did in the previous programs. Another initiative to make more consumer credit available is due to start soon. To help people and businesses with lower credit ratings, the Fed will need the backing of the Treasury, which will bear the cost of any defaults on loan securities the Fed purchases that are rated less than AAA, the official said.

The Fed is consulting with the Bush administration’s Treasury officials as well as working with Mr. Obama’s nominee to head the Treasury, Timothy F. Geithner, who currently is president of the New York Fed bank, on its next steps to ease credit markets, he said.

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

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

Stephen Stanley, an economist at RBS Greenwich Capital, said the Fed’s plans to move beyond rate reductions are unprecedented and should produce a powerful impact on Wall Street and Main Street psychology.

“The Federal Reserve has promised to do everything in its power to provide support to the financial system,” he said. “There are no practical limits to the Fed’s ability to expand its balance sheet. The Fed owns the printing press.”

Brian Bethune, an economist at IHS Global Insight, said he expects the Fed to keep aggressively buying mortgage securities to try to revive the collapsed housing market. “Mortgage lending spreads remain pathologically high,” he said.

Sung Won Sohn, University of California economics professor, said the Fed’s balance sheet could grow by another $1 trillion next year as the Fed buys up substantial portions of the securities markets for business and consumer loans.

“This type of unconventional monetary stimulus has risks. Even though inflation is in remission for now, there is a meaningful risk of an inflation bubble later, especially if the central bank is successful in stimulating the economy,” he said. “For now, Helicopter Ben has to put out the big fire and worry about the inflation bubble later.”

The prospect of the Fed and Treasury flooding the economy and financial markets with dollars through various expansionary programs has spooked some overseas investors, said David Woo, an analyst at Barclays Capital.

“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,” he said.

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