The Federal Reserve cuts the funds rate to 0.25% and announces unconventional measures to revive the economy
Call it Ben Bernanke's "shock and awe" campaign.
On Dec. 16, the Federal Reserve announced that it is attacking the recession with a more powerful arsenal than ever, including a cut in the federal funds rate to a historic low of just zero to 0.25%. The central bank is counting on a show of overwhelming force to vanquish the recession and get Americans borrowing, spending, and working again.
The stock market climbed after the announcement, with the Dow Jones industrial average closing up 359.61 points, or 4%, at 8,924. Prices had been up slightly before the announcement in anticipation of powerful Fed action. The consensus Wall Street expectation was a half-point cut.
Ten-year Treasury notes rallied on the expectation that the Fed will be buying even more of them. Their yield, which goes down when prices go up, fell to a new low of 2.3%, from 2.5%, on Dec. 15.
No Dissenters to the Vote
"Whatever it takes—that's what we do," wrote Wachovia (WB) Chief Economist John Silvia, paraphrasing the rate-setting Federal Open Market Committee. Silvia said the committee went "where no FOMC has gone before."
Usually the Fed names a particular rate for its target for the federal funds rate—most recently it was 1%. This time it named a ceiling, namely, no more than one-quarter percent. Anything below that level, down to zero, is acceptable to the Fed. That alone is a historic change.
It's a measure of the severity of the financial crisis that there were no dissenters from the Fed vote. Even inflation hawks such as Philadelphia Fed President Charles Plosser and Dallas Fed President Richard Fisher voted "yes" on the measures.
Sending the Markets a Message
The language in the statement released by the Fed was unusually strong. The central bank eschewed any effort to be even-handed about the risks of recession vs. inflation. The economic downturn is clearly Enemy No. 1.
Said the Fed: "Labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further." As for inflation, the Fed said, "inflationary pressures have diminished appreciably" and should "moderate further in coming quarters."
In an attempt to impress the markets with its resolve, the Fed made clear that it won't ease up on easy money until it is sure that its objectives have been reached. The Fed statement said it "anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."
Focusing on Assets
With no more room to cut interest rates, the Fed is turning more and more toward buying up debt in an effort to drive down interest rates. It is targeting Treasuries, the corporate debt of Fannie Mae (FNM) and Freddie Mac (FRE), and mortgage-backed securities. In recent months its assets have zoomed from around $800 billion to $2.2 trillion.
In a conference call with reporters after the 2:15 p.m. ET announcement, a senior Fed official tried to draw a distinction between what the Federal Reserve is doing and what the Bank of Japan did in its efforts to stimulate the Japanese economy during the "Lost Decade of the 1990s." The official said that Japan's central bank focused on the liability side of its balance sheet, emphasizing the expansion of cash and bank reserves in order to flood the banking system with money to lend.
In contrast, the official said, the Federal Reserve is putting its attention on the asset side of the balance sheet—buying up assets such as Treasuries and mortgage-backed securities in an attempt to drive down rates and improve the health of the overall economy and, in particular, the housing market. On the same day that the Fed made its move, the U.S. Commerce Dept. announced that new-home building starts in November fell by 19%, the sharpest monthly drop since March 1984.
New Program in the Wings
The distinction between the Japanese and American approaches is subtle because, as any accounting student knows, the asset and liability sides of the balance sheet are mirrors of each other. But under Bernanke, the Fed is clearly hoping that targeting certain key market interest rates will get lending and borrowing going again.
By its charter the Fed is not allowed to make loans or accept collateral that could expose it to a big chance of loss. That's where the Treasury Dept. comes in as a partner. In its Dec. 16 statement, the Federal Reserve served a reminder that it has a big new program in the wings in conjunction with Treasury. Starting early next year, the Fed will lend up to $200 billion to "facilitate the extension of credit to households and small businesses." To hold down the risk of losses by the Fed, the Treasury Dept. will absorb the first $20 billion in losses.
Business Exchange related topics:
Recession Spending and Investing
Fannie Mae and Freddie Mac