Wednesday, Dec. 17, 2008

Fed is trying everything it can

Key rate slashed in attempt to spur borrowing

WASHINGTON -- By cutting its benchmark lending rate to historic lows Tuesday and promising to combat the U.S. recession head-on and aggressively, the Federal Reserve served notice that more unconventional actions probably are ahead as it fights to reverse the nation's economic woes.

The Fed pushed its federal funds rate from an already low 1 percent to a target range of 0 to 0.25 percent. It is the lowest point ever for this target rate, which banks charge each other for overnight loans. The funds rate serves as a benchmark for a wide range of loans in the U.S. economy.

The Fed's rate cut was larger than expected, and highly unusual, because the Fed usually targets a specific rate instead of a range.

The move highlighted the Fed's determination to act aggressively along with the reality that the U.S. recession is rapidly deepening.

Evidence of that came from the Commerce Department, which reported that housing starts fell 19 percent in November and 47 percent on a year-over-year basis. New residential construction has fallen to levels not seen in almost a half-century.

In theory, the Fed's action should reduce the cost of borrowing for consumers and businesses, because the prime rate -- what banks charge their best customers -- moves in tandem with the federal funds rate.

The prime rate typically influences rates for car loans, student loans, credit cards and other debt. With Tuesday's cut, the prime rate is expected to fall to 3 percent to 3.25 percent from 4 percent.

However, despite the attractive rates, banks aren't lending to most consumers and businesses. Weak financial institutions continue to hoard cash and build their balance sheets, with little appetite for risk in new loans. That's worsening the economic downturn, especially since it hurts consumers.

Fed says it will 'employ all available tools'

In a statement, the rate-setting Federal Open Market Committee said: "The outlook for economic activity has weakened further ... the Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability."

Wall Street rallied on the news. The Dow Jones industrial average shot up 359.61 points to close at 8,924.14; the S&P 500 finished up 44.61 points to 913.18; and the Nasdaq added 81.55 points to end the day at 1,589.89.

The Fed has little room left to maneuver on interest-rate policy now and will use other tools.

"They are saying that they have unlimited arrows. As the central bank of the United States, it is the only entity that can write checks on itself without limit, and that's a very powerful weapon," said Marvin Goodfriend, a former research director at the Federal Reserve Bank of Richmond, Va., who's now an economics professor at Carnegie Mellon University in Pittsburgh. "It won't work immediately, but if it is used aggressively, it will work."

Chief among those other tools is to continue lending aggressively; the Fed's balance sheet has gone from about $800 billion to $2.2 trillion as it pulls out all the stops to confront the worst financial crisis since the Great Depression.

Fed Chairman Ben Bernanke next can scale up existing Fed lending facilities or create new ones, Goodfriend said. The Fed statement said the central bank was weighing the possibility of buying long-term Treasury bonds, which would drive down their yield and make other investments such as corporate and municipal bonds more attractive.

"The Fed did it before in the 1940s and it could do it again," said Vincent Reinhart, a former chief economist of the Fed's rate- setting body who's now a scholar at the American Enterprise Institute, a conservative policy institute in Washington.

The Fed's statement also said it will extend credit to households and small businesses early next year. Other experts think the Fed will increase its purchases of troubled assets to unclog credit markets.

The Fed already has become the buyer of last resort for financial products that aren't moving in today's frozen credit markets.

It has bypassed banks and is buying short-term promissory notes issued by big U.S. corporations, called commercial paper. It's also announced plans to buy pooled car loans, student loans and credit card debt, collectively called asset-backed securities.

Obama says government should 'step up'

In another creative step to boost the housing market, the central bank has been buying pooled mortgages -- called mortgage-backed securities -- and debt issued by Fannie Mae and Freddie Mac, the mortgage finance giants that the government seized in September.

"The Fed has the ability to purchase just about anything, and they will do so if they think it will help unfreeze credit markets," said Mark Zandi, chief economist for forecaster Moody's Economy.com.

President-elect Barack Obama noted Tuesday during a Chicago news conference that the Fed has cut interest rates almost as low as possible. That makes it "critical that the other branches of government step up" and work to stimulate the economy as well, Obama said, underscoring his determination to push a huge stimulus program next month upon taking office.