The Federal Reserve cut its target for the federal funds rate to a range between 0 percent and 0.25 percent and promised to keep it there “for some time.”

Fed chops rate

0-0.25%

The Fed slashed at least three-quarters of a point off a key interest rate.

By reducing the target rate from 1 percent to as low as 0 percent, the central bank acknowledged reality. The prime rate will fall to 3.25 percent. The federal funds rate had been hanging around in the Fed’s target range since Dec. 4, anyway.

The central bank said it will “employ all available tools” to stimulate the economy and prevent deflation. The Fed sent an unmistakable signal that it wants lenders to lend and consumers and businesses to borrow. It wants to discourage saving. Rates and yields on savings accounts, such as certificates of deposit, were already low and probably will fall even further.

The rate-setting Open Market Committee issued an unusually long policy statement. Instead of the usual four paragraphs, this one was seven paragraphs long. The key paragraph — a distillation of Chairman Ben Bernanke’s philosophy of how to respond to a financial crisis — was the fourth. It read:

“The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

Bernanke was a Princeton economist before joining the Federal Reserve Board, and he focused his academic career on economic depressions and how to avoid them. Many of his conclusions can be boiled down into the paragraph above, which can be rephrased as:

  • Throw everything, including the kitchen sink, at the problem.
  • Promise to keep short-term rates low until there is evidence that economic growth has resumed — lasting economic growth, not just a blip.
Don’t worry: We’ll just print more

Bernanke’s solution includes a combination of long-lasting rate cuts and something he previously has called “quantitative easing,” which essentially means printing lots of money. In its policy statement, the Fed phrased it as “sustain(ing) the size of the Federal Reserve’s balance sheet at a high level.”

Last month, the Fed announced that it would crank up the printing press to create billions of dollars and use the new money to buy mortgage-backed securities. The Fed’s goal is to drive mortgage rates lower while introducing so much money into the system that banks will lend it to consumers, businesses and other banks. The central bank reiterated that intention in this rate policy statement.

These actions are straight out of the road map that Bernanke drew in speeches in 2002 and 2004. In the 2002 speech, Bernanke, then a Fed governor, described what he called the “zero bound” problem caused by a federal funds rate at or near zero percent. “Of course, the U.S. government is not going to print money and distribute it willy-nilly,” Bernanke said. He described where the Fed could put the money:

  • It could buy U.S. Treasury bonds and notes.
  • It could lend money to banks at low interest, and accept corporate bonds, commercial paper and mortgages as collateral.
  • It could buy mortgage-backed securities.
  • With permission from Congress, it could buy corporate bonds.

The Fed already is lending money to banks and accepting all sorts of stuff as collateral, and plans to buy mortgage-backed securities soon. The central bank says it “is also evaluating the potential benefits of purchasing longer-term Treasury securities.” And under the Troubled Assets Relief Program, or TARP, the Fed and Treasury could buy corporate bonds.

In the 2004 speech, Bernanke said that, “even with the overnight nominal interest rate at zero, a central bank can impart additional stimulus by offering some form of commitment to the public to keep the short rate low for a longer period than previously expected.”

The Fed offered just this type of commitment in this policy statement, when it said, “the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

Back in August 2003, the federal funds rate was at a then-record low of 1 percent, and the Fed said in a policy statement that “policy accommodation can be maintained for a considerable period.” That, Bernanke said later, was a commitment to keep rates low for an extended time. Indeed, the Fed kept the overnight rate at 1 percent for 10 more months.

Crisis of confidence

The Fed’s actions are designed to flood the system with money and wait for investors to invest it, and for consumers to start worrying about inflation and, thus, to spend now instead of later. By targeting mortgage rates, the Fed is trying to encourage greater spending on houses.

Economists were impressed by the emphatic nature of the Fed’s policy statement. “The Fed has clearly stated that these are extraordinary times that require extraordinary actions,” says Joel Naroff, principal of Naroff Economic Advisors of Holland, Pa.

Naroff adds: “What the (Fed) is signaling is that, to paraphrase John F. Kennedy’s inaugural address, it will ‘pay any price, bear any financial market burden, meet any economic hardship, support any frozen market, oppose any negative economic activity in order to assure the survival and the success of the economy. That, and more, it has pledged.'”

The reduction might not have any effect on lenders’ behavior, worries Stephen Buser, finance professor emeritus at Ohio State University.

“It doesn’t matter,” Buser says. “At this point it’s all public relations. Interest rates are not the constraint on borrowing and lending. They used to be. But this particular episode is a crisis of confidence, so there are lenders with lots of cash.”

What’s needed, Buser says, is for the government to help banks that own toxic assets (such as bad mortgage-backed securities) and, just as important, to identify which banks are healthy. That would inject trust in the system and stimulate borrowing, he says.

He likens today’s problems in the financial system to the Tylenol scare in the early 1980s, when someone put poison in capsules of Extra-Strength Tylenol and returned the spiked bottles to store shelves. The drug maker and the government cooperated transparently and cleared all store shelves of Tylenol products. Soon after, Tylenol returned to the shelves in tamper-resistant packages, and people quickly bought the pain reliever again.

Buser says the response to the credit crisis lacks such transparency — and until there is clarity, lower interest rates won’t solve the credit crisis.

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