The Federal Reserve's decision to cut its target for short-term interest rates to as low as zero reflects the reality of a central bank scrambling to apply a new set of monetary tools to battle the deepening recession.
“These are extraordinary times that call for extraordinary measures,” said Robert McTeer, former president of the Dallas Federal Reserve Bank.
In an unprecedented move, Fed Chairman Ben Bernanke and his colleagues Tuesday set a new target range for overnight lending between banks at zero to 0.25 percent, down from the previous target of 1 percent.
The decision was just one of several bold and unexpected steps announced by the Fed. In an unusually extensive statement, the central bank acknowledged that the weakening economy called for an expanded range of responses and pledged to use “all available tools” to get growth back on track.
Those tools include an aggressive buying spree of public and private debt securities that the central bank began in September. The Fed reiterated Tuesday that it intends to buy “large quantities of agency debt and mortgage-backed securities” and announced that it is considering buying longer-term Treasury securities. In addition the Fed will consider other “ways of using its balance sheet to further support credit markets and economic activity.”
Over the past three months of financial crisis, the Fed has unveiled an alphabet soup of new programs — from the Term Auction Facility to the Commercial Paper Funding Facility — with one common goal: buying up debts that no one else wants and swapping them for cash.
Those efforts to flood the financial system with cash have been far more important than the rate-setting that is usually the Fed's most effective tool. The Fed's decision to announce a target range of zero to 0.25 percent is an acknowledgement that the central bank has been unable to meet its stated target rate through normal purchase and sale of Treasuries in the open market.
Although the Fed has had a target of 1 percent since Oct. 29, the actual market-based rate has fallen as low as 0.125 percent in recent weeks due to slack demand for short-term borrowing.
With short-term interest rates effectively at zero, the Fed can do little more to lower the cost of borrowing. The hope is that by pumping trillions of dollars of cash into the credit system by buying up securities, that money will find its way into the hands of cash-strapped consumers and businesses to help revive the economy.
With more than a half million jobs lost in November alone, the government provided fresh data Tuesday on just how much deeper the recession has become.
Shrinking demand sent consumer prices last month on their biggest slide since records were first kept 61 years ago, the Labor Department reported. Prices fell 1.7 percent, due largely to the deep slide in energy costs.
In a separate report, the Commerce Department reported that construction of new homes fell in November by 18.9 percent, the biggest drop in a quarter-century. The decline pushed construction down to a seasonally adjusted annual rate of 625,000 homes, the slowest pace on records dating to 1959.
Now as banks, companies and consumers all struggle to pay down a mountain of debt taken on during the easy-money years of the first half of the decade, spending and investment have slowed to a crawl and new credit has dried up. To fill the hole created by that huge private sector debt, the Fed is now taking unprecedented levels of debt onto its own books, and swapping that debt for cash to try to get money flowing normally again through the financial system.
“We're in a change in regime in terms of policy, where the focus is switching away from the federal funds rate to other actions the Fed can take with its balance sheet to improve financial conditions and encourage the flow of credit,” said former Fed Gov. Laurence Meyer, now vice chairman of Macroeconomic Advisers.
With short-term interest rates already close to zero, the Fed has been moving to a strategy known as “quantitative easing” — essentially dumping money into the economy to make credit easier to get. Early in his tenure as a board member, Fed Chairman Ben Bernanke described the policy by likening it to dropping money from a helicopter, a speech that earned him the nickname “Helicopter Ben.”
“The (target interest) rate is the least important issue right now,” said Diane Swonk, chief financial officer of Mesirow Financial. “It will be the alternative actions — the helicopter in the sky and how much money they're going to drop from the helicopter.”
Those helicopter drops aren’t being announced with the same fanfare as the Fed’s changes interest rate policy. But they’ve been showing up in the weekly statistics the central bank provides on its balance sheet, the accounting of overall assets and liabilities.
Since the beginning of September, the Fed’s books have swollen as it has been buying debt assets from banks and corporations — paying cash in an effort to pump more money into the system. In the past three months, the Fed’s balance sheet has jumped to $2.3 trillion after holding steady for almost a year at about $900 billion.
The central bank is also shifting its emphasis on the kinds of debts it is buying. Under normal circumstances, the Fed’s so-called “open market operations” involve buying and selling U.S. Treasuries to fine tune the rate charged on short-term loans.
But the global financial meltdown has already sent private buyers stampeding to buy Treasuries, pushing rates to zero as investors seek the safety of securities backed by the U.S. government. (For brief periods, the rate on short-term Treasuries has fallen below zero, as investors accept a slight loss in return for the assurance they’ll get their money back.)
As a result, the Fed has turned to buying other kinds of debt securities, including the so-called “commercial paper” that companies and banks sell to fund their borrowing. Last month, the Fed announced it would buy $600 billion in debt and mortgage-backed securities from mortgage giants Fannie Mae and Freddie Mac. With investors shying away from mortgage-backed debt, the Fed is hoping to supply more cash to that market to try to push mortgage rates lower.
“it's beginning to matter more what the Fed buys to expand money and liquidity than how much is expanded,” said McTeer. “They've started buying other than Treasury bills to unfreeze some of these markets.”
With the economy shrinking and unemployment rising rapidly, the Fed’s move to flood the system with money will take time to have an effect. Economists expect the economy to continue to shrink at least through the middle of next year, if all goes well.
Those forecasts also anticipate another major spending program by the government to stimulate the economy. President-elect Obama’s transition team is already working with Congress on a spending package that could approach $1 trillion, according to published reports.
“It is critical that the other branches of government step up,” Obama told reporters at a news conference Tuesday.
Under normal circumstances, this flood of government spending and asset purchases by the Fed would pose a major risk of inflation. Economists say that long-term threat is very real. But for the moment, the ongoing drop in prices of assets like housing and stocks to commodities like gasoline has pushed that inflation risk into the future.
Falling prices have also helped ease the credit burden on consumers. The sharp drop in energy prices — gasoline prices have dropped 87 percent in the past three months — has boosted consumers’ spending power buy about $130 billion, according to RDQ chief economist John Ryding.
“We’ve had a huge tax cut,” said Stuart Hoffman, Chief Economist at PNC Financial. “The catch is you've got to have a job.”
Though falling prices boost consumers' spending power, a continued slide, known as deflation, can be even more damaging to the economy. Once deflation takes hold, consumers delay purchases, companies adjust to lower demand by slowing production and cutting jobs, which causes consumers to scale back spending even more. The downward spiral feeds on itself.
The Fed is hoping to prevent that from happening by “inflating” the economy with its multi-trillion-dollar buyback of debt. But as the economy recovers, the Fed’s new strategy of “quantitative easing” will pose a new set of challenges.
At some point, once the economy begins to recover, the Fed will face yet another monumental challenge: how to drain trillions of dollars of excess cash from the economy to avoid a new bout of inflation or another credit bubble. If it starts draining money too soon, it risks throwing the economy into another slide. That means the Fed’s outsized role in managing the economy with its new strategy will likely remain in place for some time to come, according to Credit Suisse chief economist Neil Soss.
“There is no exit strategy from this entanglement, anywhere,” he wrote in a note to clients this week.
(The Associated Press contributed.)