The Fed Moves Beyond the Rate Cut
Will the Federal Reserve cut rates again on Dec. 16? Maybe a better question is: Should investors care if it does? That's because the Fed is taking a giant leap beyond its traditional rate-setting strategy. Since mid-September it has been moving toward a new policy called quantitative easing that gives much less attention to the target rate. Instead of trying to influence financial market results by controlling the overnight rate at which banks lend to each other, as it has done since the 1980s, the Fed increasingly is intervening in a number of other markets as well. These actions do more than pump enormous amounts of funds into the system, which is crucial to stabilizing the markets. They can also directly affect the rates on other types of credit, thus offering more stimulus to the economy than conventional efforts.
Amid dysfunctional credit markets, standard rate cutting is simply not working as a way to revive the economy. The Fed has already lowered its target for interbank borrowing to 1% with no apparent effect. As Fed Chairman Ben Bernanke said on Dec. 1, "at this point the scope for using conventional interest rate policies is obviously limited."
Quantitative easing, commonly called "printing money," essentially supplies more funds to the banking system than are needed to maintain the Fed's interest rate target. Prior to mid-September, the Fed had been neutralizing the impact of its new lending facilities on the target rate by selling some of its Treasury bills, which drains away the excess funds.
Not anymore. Until the Sept. 15 bankruptcy of Lehman Brothers, excess reserves, or those funds available for trading between banks in the overnight markets, had typically averaged about $2 billion a week. Since then they have exploded to an unprecedented $605 billion a week on Nov. 19. As a result, interbank funds are already trading well below the Fed's 1% target rate. That means actual policy is even looser than the target rate indicates, so a cut to 0.5% would not be a meaningful change in policy. Plus, if not for the Fed's new program of paying banks interest on the reserves they hold at the Fed, the interbank rate would have fallen to zero by now.
The Bank of Japan embraced quantitative easing from 2001-06, when it lowered its target rate to near zero in an attempt to pull the economy out of its long deflationary tailspin. The Fed's efforts are already far more aggressive than the BOJ's. Economists at research firm Capital Economics in London note that total bank reserves in Japan rose fivefold in the first year of this policy, but U.S. reserves have already grown nearly fourteenfold in about two months.
The Fed's Nov. 25 decision to begin buying up to $600 billion in mortgage debt and mortgage-backed securities from Fannie Mae (FNM), Freddie Mac (FRE), and the Federal Home Loan Banks is the biggest step yet in this new strategy. That plan, not even begun yet, has already sharply reduced mortgage rates and lifted the value of many mortgage-backed securities sitting on bank balance sheets. Both trends are expected to continue, and a wave of refinancing for homeowners with good credit and home equity seems likely. This program, plus the Fed's plan to lend up to $200 billion to holders of securities backed by credit-card debt, auto loans, and small business loans should breathe some life into the moribund securitization process that is so crucial to the flow of credit.
The Fed's new direction may be the best way to heal the markets and the economy. But Japan's experience showed the strategy did little to boost lending. Right now in the U.S. there is little desire to lend or borrow. There's also the long-term risk that flooding the system with money will spark inflation. Eventually, the Fed will have to sop up all that extra lending potential, but Bernanke says that's an issue for the future. "For now," he says, "the goal of policy must be to support financial markets and the economy." In other words, whatever it takes.