US Fed cuts key interest rate - how low can it go?(updated)

  • Business
  • Thursday, 30 Oct 2008

WASHINGTON: Just how far will the Federal Reserve go in lowering interest rates to save the country from a long and painful recession?

Ratcheting its key rate from the current 1 percent all the way down to zero can't be ruled out.

But there are risks in taking such an unprecedented step: namely, that it wouldn't work in turning around the economy and breaking through a stubborn credit clog.

Eventually, a zero percent rate - virtually "free'' loans for banks - could trigger a speculative investment frenzy that could feed a bubble that pops, wreaking havoc on the economy.

Former Fed Chairman Alan Greenspan - now partly blamed for the current problems - has called today's crisis a "once-in-a-century credit tsunami.''

Emphatic as it was, the bold rate reduction the Fed ordered Wednesday and the possibility of even lower rates ahead are no panacea.

Even lower rates won't necessarily entice skittish Americans to spend and squeezed banks to lend more freely - forces at the heart of the economic woes.

With any luck, though, the Fed's action will cushion the blow to the country, which is on the brink of _ or already in - its first recession since 2001.

The Fed slashed its key rate by half a percentage point to 1 percent, a rate not seen since 2003 and part of 2004. The rate hasn't been lower since 1958.

In a gloomier assessment of the economy, Fed policymakers said "the pace of economic activity appears to have slowed markedly'' as consumers and businesses cut back on spending, and economic slowdowns in other countries sap demand for U.S. exports, which have helped keep the economy afloat.

Moreover, the "intensification of financial market turmoil'' is likely to weigh on consumers and businesses, further reducing their ability to borrow money, the Fed said.

Underscoring the Fed's sense of urgency is this fact: It took just 13 months for Fed Chairman Ben Bernanke, a student of the Great Depression, to ratchet down rates to the 1 percent mark.

It took his predecessor, Greenspan, 2{ years.

Many economists predict Fed policymakers will drop the rate again to half a percentage point, which would mark an all-time low, on or before Dec. 16 - its last scheduled meeting of the year.

The Fed left the door wide open to more rate cuts, pledging to "act as needed'' to revive the economy.

"We are in a crisis situation and everything is on the table,'' said Richard Yamarone, an economist at Argus Research.

"If conditions deteriorate considerably, the Fed could go down to zero. It is absolutely a possibility, but I don't believe it is likely.''

Yet even if the Fed were to lower its key rate to zero, that might not reverse the bunker mentality of consumers and lead them to ramp up spending.

More than in recent recessions, consumers have retrenched as vanishing jobs, shrinking paychecks and nest eggs, and sinking home values have made them feel less wealthy and less inclined to spend.

Consumer spending - the single biggest chunk of overall economic activity - probably fell in the July-to-September quarter.

That would mark the first quarterly drop since late 1991, when the country was emerging from a recession.

And just because borrowing costs are cheaper doesn't mean banks will feel more inclined to increase lending to people and businesses.

"The problem is not the interest rate,'' said Sean Snaith, an economics professor at the University of Central Florida.

"It is that no one is willing to loan, regardless of what the rate is. Lower rates will not make the problem go away. The credit crunch will take time to resolve. This is another action to just chip away at the gridlock in this economy, but we shouldn't expect a miraculous turn of events from this.''

The Fed's move Wednesday meant the prime lending rate used to peg rates on home equity loans, certain credit cards and other consumer loans dropped to 4 percent.

Even if the Fed were to cut its main rate to zero, the prime rate would fall to 3 percent but no lower.

The Fed's previous rate reductions, in fact, were blunted by the credit crunch.

The Fed slashed rates by a whopping 3.25 percentage points, from 5.25 percent to 2 percent, between September 2007 and April 2008, one of the most aggressive campaigns in decades. On Oct. 8, the Fed lowered rates again to 1.5 percent in a coordinated action with other central banks around the world.

The Fed probably would want to stop short of zero, so it saves precious ammunition - meaning additional rate cuts - should the economy take a turn for the worse later on, some economists said.

Others believe the Fed would want to avoid the fate of Japan, which failed to revive its economy even after its central bank slashed rates to zero in 1999 and kept them there for six years before bumping them up again.

Japan became mired in a decade of lost growth in the 1990s after real-estate prices collapsed.

That caused a severe bout of deflation, which is a destabilizing drop in prices.

"Cutting rates to zero is a fairly desperate measure, and a lot of stigma is attached to it,'' Snaith said.

"It would bring on comparisons to Japan.''

There's also the worry that dropping rates to all-time lows would feed the type of speculative boom and painful bust that the country is now suffering through.

Greenspan lowered rates to 1 percent in summer 2003 as he sought to aid the economy's slow recovery from the 2001 recession and fend off a remote - but dangerous _ risk of deflation.

He kept rates at that historically low level for a year.

Critics contend that those low rates fed the housing bubble and lax lending standards that eventually burst and imperiled the economy.

The meltdown drove up foreclosures and forced financial companies to rack up huge losses on soured mortgage investments, laying low storied Wall Street firms and causing banks to fail.

Instead of dropping rates to zero, the Fed probably will turn to other weapons to battle the crisis.

The Fed has already created first-of-its-kind programs, such as getting cash directly to companies by buying up mounds of "commercial paper,'' the short-term debt firms use to pay everyday expenses such as payroll and supplies.

That program, which started Monday, is helping to relieve credit stresses, economists said.

The Fed also is providing loans to banks, has moved to provide a financial backstop to the mutual fund industry and has injected billions of dollars in financial markets here and abroad.

The Fed could opt to expand programs by enlarging loans it's now making, providing loans to other types of companies, or buying more and different types of debt.

The Fed's balance sheet has doubled to $1.8 trillion in recent months, reflecting those other activities to get credit flowing again.

Because the Fed has wide latitude in these areas, many economists believe Fed policymakers are more likely to continue this route than to lower its key rate to zero.

No matter the relief tactics, though, the economy is due for more pain.

The unemployment rate, now 6.1 percent, could hit 8 percent or higher by next year. Home prices are likely to keep sinking for some time, and nest eggs will continue to be battered.

"We've been in pain, and it will get much more severe over the next six months,'' predicted Mark Zandi, chief economist at Moody's

"The economic damage of the financial panic has already been done, and the Fed is trying to limit the damage as best it can.''

Earlier report

WASHINGTON: The Federal Reserve slashed a key interest rate by half a percentage point Wednesday, driving it to a level seen only once before in the last half-century, and the government finally began distributing funds from the billions in the financial rescue package.

Those efforts and others were part of a concerted drive by officials, just days before a national election, to demonstrate they are moving as quickly as possible to deal with the most serious financial crisis to hit the country since the 1930s.

"Policymakers have their foot to the accelerator and they are using every effort at their disposal to stop the slide in the economy and financial markets," said Mark Zandi, chief economist with Moody's

"And it's not a moment too soon given the serious damage that has already been done."

Wall Street, which the previous day posted the second biggest point gain in history, was less impressed with Wednesday's activity.

The Dow Jones industrial average finished the day down 74 points, a drop analysts said partly reflected growing worries about whether the government's actions will be sufficient to avert a deep and prolonged recession.

The Fed, as investors had hoped, announced a half-point cut in the federal funds rate, the interest that banks charge each other on overnight loans, driving it down to 1 percent, a low last seen in 2003-2004.

That rate has not been lower since 1958 when Dwight Eisenhower was president.

Reducing the rate as low as zero cannot be ruled out, some analysts said, but they cautioned that reducing rates that far carried some risks, including that if the credit crisis suddenly worsened, the Fed would have used up its ammunition.

Analysts also noted that just lowering rates cannot serve as a panacea to overcome a credit crisis.

While the goal is to encourage banks to begin lending again, financial institutions are skittish about extending new loans given the huge losses they have racked up in bad mortgages.

Meanwhile, the administration announced that the spigot had been opened on the $700 billion fund created by Congress Oct. 3 to rescue the U.S. financial system.

Treasury issued a report showing checks had been disbursed for $125 billion in payments to nine major banks, including Bank of America, Citigroup, JPMorgan Chase, Goldman Sachs and Morgan Stanley.

The goal is to bolster their balance sheets so they will resume more normal lending.

And the administration was nearing an agreement on a plan to help around 3 million homeowners avoid foreclosure, according to sources who had been briefed on the matter.

The program would be the most aggressive effort yet to limit damages from the severe housing slump.

Besides cutting interest rates, the Fed announced it was extending credit lines worth $30 billion each to the central banks of Brazil, Mexico, South Korea and Singapore in an effort to bolster financial markets in those countries and relieve investors' anxieties.

It brought to 14 the number of central banks that the Fed has entered into so-called swap arrangements for currency as a way to pump more liquidity into global credit markets, part of an effort that the Bank of England estimated has resulted in $5 trillion in support being put forward by governments worldwide.

The International Monetary Fund unveiled a new streamlined lending process to get support to countries caught up in the credit crisis, another effort by the 185-member institution to show it was prepared to perform its job as lender of last resort to countries facing difficulties.

The IMF already has moved to help Iceland, Ukraine and Hungary with other nations quickly lining up for aid.

The Fed's half-point interest rate cut marked the second rate reduction this month.

The Fed slashed the rate by a half-point on Oct. 8 in a coordinated action with other foreign central banks.

Economists predict foreign central banks will follow suit with another round of rate cuts over the next week.

In a brief statement explaining Wednesday's action, the Fed said that the "intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and business to obtain credit."

The central bank said that "downside risks to growth remain" holding out the promise of further rate cuts if needed.

The rate-cut decision was unanimous.

Federal Reserve Chairman Ben Bernanke and his colleagues pledged they would "monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability."

Many analysts said they believe the Fed will not stop at 1 percent if officials see the need to cut rates further.

Some are forecasting another half-point move at the Fed's last meeting of the year on Dec. 16.

But other economists said with rates already so low, the Fed may decide to hold at 1 percent, leaving some room for a further reduction next year should the country's economic troubles intensify.

The Fed's action was quickly followed by a reduction by commercial banks in their prime lending rate, the benchmark for millions of consumer and business loans, which was cut from 4.5 percent down to 4 percent, its lowest level in four years.

The central bank also announced that it was lowering its discount rate, the interest it charges to make direct loans to banks, by a half-point to 1.25 percent.

This rate has become increasingly important as the central bank has dramatically increased direct loans to banks in an effort to break the grip of the credit crisis.

All the frenzied activity is occurring against a backdrop of an economy that has slowed noticeably.

The government will release its first look at overall activity in the July-September quarter on Thursday.

The data are expected to show a decline of 0.5 percent at an annual rate, the first of what many private economists believe will be the first of two or more quarterly declines, fulfilling the classic definition of a recession. - AP

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