Even as Federal Reserve officials slashed their key interest rate to a record low and pledged to use other unconventional tools to fight the worst financial crisis since the 1930s, they still feared the economy would be stuck in a painful rut for some time.
Documents released Tuesday provided insights into the Fed’s historic decision to ratchet down its rate to near zero from 1 percent at its Dec. 15-16 meeting. In the first action of its kind in the Fed’s 95-year history, Fed Chairman Ben Bernanke and his colleagues created a target range for its rate, putting it at zero to 0.25 percent.
Despite the aggressive action, “the economic outlook would remain weak for a time and the downside risks to economic activity would be substantial,” according to the Fed document.
In fact, Fed officials expected the economy would “contract sharply” in the final three months of 2008 and in “early 2009,” the document said. Some participants suggested “the distinct possibility of a prolonged contraction, although that was not judged to be the most likely outcome.”
Against that backdrop, Fed officials last month signaled rates would stay at record low levels for a while in an effort to cushion the blows from a recession that started in December 2007.
The housing, credit and financial debacles have badly hurt the economy. Problems have fed on each other, a vicious cycle that Bernanke and other policymakers have been desperately working to break.
Unemployment bolted to a 15-year high of 6.7 percent in November and is expected to hit 7 percent in December when the government releases that report on Friday. The economy has lost nearly 2 million jobs since the recession started. And, the Dow Jones industrial plunged nearly 34 percent in 2008, the worst showing since 1931.
Vanishing jobs and shrinking nest eggs have forced consumers to cut back sharply, jolting the economy into reverse. Many believe the economy fell backward at a rate of 5 to 6 percent in the final quarter of last year and is still shrinking.
Most Fed officials believed that the benefits of keeping rates “close to, but slightly above zero probably outweighed the adverse effects.” The Fed didn’t discuss those adverse effects but they would include the potential for spurring inflation down the road.
Fed officials thought it was important to let investors know that rates “were likely to stay exceptionally low for some time” because it could lead to a much-desired drop in longer-term interest rates. To that end, shortly after the Fed’s December decision, mortgage rates started dropping sharply. Rates on 30-year mortgages fell to 5.1 percent, the lowest on records dating back to 1971, Freddie Mac reported last week.
In discussing the best strategy on rates at the December meeting, some members wondered whether the Fed should not set a target for its key rate, which would focus attention on the Fed’s other efforts to turn around the ailing economy. But other members thought that not announcing a targeted interest rate might confuse investors.
In the end, the Fed officials agreed to create the new range — from zero to 0.25 percent. Fed officials decided it would be preferable to “communicate explicitly that it wanted federal funds to trade at very low rates.”
In terms of other tools to aid the economy, the Fed discussed the benefits of buying longer-term Treasury and other securities. Many officials also thought the Fed should consider whether expanding some of its existing programs to provide loans or to buy debt would be helpful or whether new programs should be created.
The Fed on Monday started buying mortgage-backed securities, part of a program announced in November to help bolster the crippled housing market.
Fed officials at the December meeting also discussed possible refinements to its economic projections. It didn’t provide details. No decisions were made on that front.