By John W. Schoen Senior producer
msnbc.com
updated 11/26/2008 3:47:00 PM ET 2008-11-26T20:47:00

This week's move by the Treasury and Federal Reserve to inject another $800 billion into the financial system opens yet another chapter in the government's continually evolving response to the financial crisis. But the announcement reflects a policy that has been evolving behind the scenes at the Federal Reserve for months with little fanfare.

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Add one more acronym to the alphabet soup of financial rescue programs:  zero interest rate policy, or ZIRP. But ZIRP is not just another bailout program.

ZIRP represents a major shift in the Fed's monetary policy, which typically involves managing lending rates and adding or draining cash to the banking system. But the central bank is running out of room to lower interest rates, and banks are hoarding much of the fresh cash they have received from the Treasury. So the Fed is bypassing the banking system and pumping money directly into the financial system to try to revive economic growth.

So far it is hard to tell whether it is working. A fresh ream of reports out Wednesday was not encouraging.

Consumers cut spending by 1 percent during October, faster than at any time since the terrorist attacks of Sept. 11, 2001, according to one report. A separate survey showed that consumer confidence fell this month to a 28-year low.

Orders for costly durable goods like cars, machinery and computers tumbled a steeper-than-expected 6.2 percent in October. And the Labor Department reported that 529,000 workers filed new claims for unemployment benefits in the latest week, a bit fewer than the week before but still a level generally seen only during recessions.

As nominal short-term interest rates have approached zero, the Federal Reserve under Chairman Ben Bernanke has injected hundreds of billions of dollars into the economy through a variety of programs, with varying degrees of success. Since early September, the value of assets held by the Fed has exploded from about $950 billion to more than $2.2 trillion — not including Tuesday’s announced purchases.

The Fed has offered little detail about the assets it is buying, making it difficult to estimate how risky or effective the moves will be. These massive investments are aimed at heading off a catastrophic downturn, although most economists believe the economy already is in the deepest recession in more than a quarter-century.

“We have a joint venture going on between the Treasury and the Fed to essentially create a  government-sponsored banking system, if I can call it that, to substitute for the private sector banking system that is not wanting to lend,” said Paul McCulley, an investment manager at PIMCO, the giant money management firm.

Until September, the Fed’s primary response to the credit crunch and weakening economy was to slash short-term interest rates — cutting its target bank lending rate to just 1 percent from over 5 percent as recently as last year. But those rate cuts have done little to unclog frozen credit markets or reverse the effects of a housing market collapse that has wreaked havoc on the economy.

On Tuesday the government reported the nation's gross domestic product shrank by a half-percent in the third quarter — the biggest drop since the 2001 recession. Consumer spending fell by 3.7 percent, the first decline since 1991 and the worst since 1980.

Even before those figures were released, economists were slashing their forecasts. On Friday, Goldman Sachs chief U.S. economist Jan Hatzius revised his estimates to show GDP falling at a 5 percent annual rate in the current quarter and unemployment rising to 9 percent by the end of next year from the current 6.5 percent.

"The U.S. recession is set to get worse — a lot worse — in the next couple of quarters,” said Nariman Behravesh, chief economist at IHS Global Insight in a note to clients Tuesday.

Behravesh estimates that if Congress and the Obama administration pass a new economic stimulus package worth $500 billion to $700 billion, it could add about 1 percentage point to growth in 2009 and 2010. But he says it’s probably won’t come soon enough to boost growth in the first half of 2009.

“We are in the early stages of one of the worst recessions in the postwar period, even factoring in a massive stimulus program,” he said.

The Fed's efforts to flood the financial system with cash are aimed at offsetting a massive destruction of capital — from consumers 401(k) accounts to banks' balance sheets.

The falling value of financial assets — from stocks to housing to mortgages backed by those houses — has wiped out trillions of dollars in wealth. If that deflation continues, along with the recent sharp drop in prices of commodities from oil to steel to paper, the downward spiral could become much more difficult to stop.

That threat was the subject of a 2002 speech by Bernanke, then a Fed governor, in which he described a “helicopter drop” of money as one of the Fed’s most powerful tools to fight deflation and earned him the nickname “Helicopter Ben."

Now that Bernanke is chairman, the Fed has distributed billions by a variety of ways, including buying up unwanted assets through programs with names like Term Auction Lending Facility, Term Securities Lending Facility and Asset Backed Commercial Paper Money Market Mutual Fund Lending Facility.

These efforts represents the unannounced creation one of the most powerful monetary tools the Fed has ever employed. Also known as “quantitative easing,” the zero interest rate policy is designed to reduce the cost of borrowing — even after the Fed cuts its benchmark rates to zero. Last used by the Bank of Japan to try to rescue that nation’s economy from a decadelong economic slump, the policy represents a fundamental shift for U.S. central bankers.

Though the Fed’s official overnight target rate still stands at 1 percent, the rapid buyback of bad assets has pumped more than $1 trillion in cash onto the financial system in a matter of weeks, forcing the effective rate below 0.25 percent early this month. The scope of the Fed’s buyback of bad debts has been as historic as the credit crunch the Fed is trying to overcome. Since early September, the value of assets held by the Fed has exploded from about $950 billion to more than $2.2 trillion — not including Tuesday’s announced purchases.

Though the Fed’s actions may head off further damage to the economic and financial markets, they carry their own risks.

For now, the Fed has had little trouble raising trillions of dollars to fund its buying spree. In theory, the central bank can raise as much cash as needed simply by issuing more of its own Federal Reserve notes — also known as dollars.

Much of the Fed’s spending money so far has been coming from “supplementary financing” from the Treasury, which continues to see strong demand for its own notes as investors around the world seek shelter from the financial storm. During the worst market turbulence, demand for Treasury notes has been so strong that interest rates on those notes have fallen below zero —which means investors are willing to lose a small amount of money in return for preventing bigger losses. That demand has also sent the value of the dollar soaring.

“We have a lot more latitude in expanding the Fed's balance sheet now that the U.S. dollar —and six months ago it was not the case — today is the undisputed reserve currency of the world,” said Diane Swonk, chief economist at Mesirow Financial, a Chicago-based investment management firm.

For now, the dollar’s strength is a vote of confidence from global investors. If that confidence wavers, the Fed could find itself with a lot less room to maneuver.

Over the longer term, the Treasury and the Fed are trying to use the same leverage —essentially, using borrowed money — that got the financial system into trouble in the first place.

That credit, or liquidity, is supposed to fill the void created by the collapse in the credit bubble created by the private sector. For the time being the Fed and the Treasury may have no choice but to step in as “lender of last resort.”  But at some point, the Fed will have to drain that cash out of the system or risk creating another credit bubble. It’s far from clear what impact the unwinding process will have.

”When you look at the scope of what the Fed is doing, I think the market is much more concerned about the long-term effects right now,” said Atlanta-based investment adviser Scott Kays.

The other major risk of dropping trillions of dollars onto the economy from a helicopter is that all that money could sow the seeds of massive inflation when the global economy begins to recover. But at the moment, the rapid contraction in lending and economic growth is helping to push inflation fears farther into the future.

“When I look out five to 10 years, my gut tells me that there's got to be some sort of inflation payback as a consequence of all this money creation,” said Paul McCulley, a portfolio manager at PIMCO. “That's just a visceral feeling that I think we all have. But over the next year or two, I simply don't see it. It's further and further out on the horizon.”

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