Federal Reserve Slashes Key Rate Nearly to Zero

The Federal Reserve chopped its target interest rate to a range of zero to 0.25% Tuesday.
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Federal Reserve

chopped its target interest rate to a range of zero to 0.25% Tuesday, in an attempt to relieve stopped-up flows of credit in a rapidly sinking economy.

The larger-than-expected cut brings the central bank's target rate in line with the effective federal funds rate, the actual rate of overnight lending between banks. The effective rate has been closer to 0.15%, reflecting the dismal credit environment, said Paul Mendelsohn, chief investment strategist at Windham Financial.

"Since the committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined," the Fed said in its statement. "Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further."

Noting that the threat of inflation will probably moderate in upcoming quarters, the Fed said that conditions warrant "exceptionally low levels of the federal funds rate for some time."

The Fed said it would go forward with its previously announced plans to buy mortgage-backed securities and would enact its Term Asset-Backed Securities Loan Facility, or TALF, early next year. The agency further announced it was investigating the benefits of buying longer-term Treasury securities.

Offering a target range reflects a departure from the Fed's standard procedure. The central bank has since 1995 explicitly stated a target level for the fed funds rate. Since that time, the target has never dipped below 1%.

"This is the lowest

the target rate has ever been. Full stop. End of story," said David Ader, bond strategist for RBS Greenwich Capital. "It's an amazing event, really."

Ader said that the Fed's move indicates that it has moved beyond monetary policy and into the area of quantitative easing. "This is it. They've just ended what the Fed can do here. Monetary policy for this cycle is completed," he said. The Fed is now buying duration, in the form of longer-term Treasuries or mortgages, Ader says.

Ader said it was especially significant that the central bank was ready to expand its planned purchases of debt and mortgage-backed securities, programs that have not yet been implemented.

"You've got the Fed throwing everything at this," he said.

The last time the Fed cut rates on Oct. 29, it took its target down 50 basis points to 1%. The key interest rate had last been at 1% from June 2003 to June 2004.

Designed to facilitate borrowing and, in turn, spending, interest-rate cuts can be a tool to stimulate economic growth. In that sense, the Fed's decision is fitting; the U.S. economy has been in


since last December.

Before the Fed's action, a


poll of rate-cut forecasters had indicated analysts were expecting the cut to come in at 50 basis points. Although futures contracts seemed to imply expectations for a 75-basis-point cut, the recent disconnect between the Fed's target rate and the actual lending rate among banks -- the effective fed funds rate -- accounts for that difference, wrote Tony Crescenzi on his



In the past year, the Fed has cut rates by 3.75 percentage points in an attempt to entice nervous banks to resume lending. Mortgage rates, commercial paper and other forms of debt that form the core of the current economic crisis have in many cases proven unresponsive to the Fed's interest-rate adjustments.

Mike Feroli, U.S. economist at JPMorgan Chase, said that reducing the interest rate to zero makes sense as a signal that the agency is clued in to the crisis. "If they want to make their actions consistent with their words, I think they should cut to zero," he says.

Despite the latest rate cut's apparently limited impact, other initiatives by the Fed and Treasury Department have proven somewhat effective. The $700 billion Troubled Asset Relief Program, or TARP, under which the government has taken equity stakes in major financial firms may have stemmed the panic surrounding participating institutions, which include

JPMorgan Chase

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Bank of America

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Wells Fargo

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Goldman Sachs

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Another Fed plan to buy $500 billion in mortgage-backed securities, announced earlier this year, has apparently yielded a corresponding thawing in mortgage rates.

"I do believe the idea that you're not out of tools when you get to zero," said Feroli of the fed funds rate. He said that the mortgage-purchase program has resulted in improvements in the mortgage market. "If they continue along that line, you could actually potentially do a lot of good for the credit market," he said.

Mendelsohn said that comments on alternative strategies are important. However, creating expectations around additional liquidity measures could backfire if the new programs turn out not to work. Such an event could further shake confidence in the system, said Mendelsohn.

Feroli said he was skeptical that the Fed would engage other drastic measures, such as capping longer-term rates or directly buying U.S. Treasury securities. However, he did note that purchasing mortgages used to be viewed with a high level of skepticism, and that the ideal of letting the market operate without government intervention has already been taken off the table.

The rate cut will have a substantive impact in at least one important sense. The cut, ranging from 75 to 100 basis points, will spur a corresponding reduction in the prime rate, which had been at 4%. The prime rate governs loans for small businesses and consumers and influences rates on credit cards and home equity loans, among other forms of debt.

In terms of offering resolution to the credit crisis, however, the financial system's current weaknesses apparently go beyond the reach of the Fed's target interest rate.

"Monetary policy by itself can't change confidence," Mendelsohn says. "Changing consumer confidence and investor confidence is going to be a much tougher job."