Fed Slashes Interest Rates to a 0.0% to 0.25% Target Range ... But Now What?

By Mike Caggeso
Associate Editor
Money Morning

As expected, U.S. Federal Reserve policymakers slashed a benchmark interest rate yesterday (Tuesday). But they cut it by a bigger-than-expected amount, and did so in an unconventional manner.

Instead of establishing a new, specific primary interest rate, the central bank’s Federal Open Market Committee (FOMC) voted for a target range – 0.0% to 0.25% – a record low. Before yesterday’s cut, the Federal Funds target rate stood at 1.0%.

Instead of addressing the reason for its peculiar target range, the Federal Reserve opted for canned doomsday language that could have appeared verbatim in any of its previous rate cut announcements: It hasn’t been good. It doesn’t look good. And we’re trying to fix it.

Most cryptically, the FOMC said it “will employ all available tools” to promote economic growth and price stability. But those objectives could take some time to achieve.

“The committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time,” the Fed said in a statement.  

U.S. stocks soared on the Fed announcement, with the Dow Jones Industrial Average gaining 359.61 points, an increase of 4.2%, to close at 8,924.14. The Standard & Poor’s 500 Index jumped 44.61 points, or 5.14%, to finish the day at 913.18. The tech-laden Nasdaq Composite Index jumped 5.41%.

Since September 2007, U.S. Federal Reserve policymakers have cut the benchmark Fed Funds target rate 10 times – taking it from its starting point at 5.25% to the current rate range, hoping it would encourage bank-to-bank lending, as well as bank-to-consumer lending.

“It's a highly unorthodox and creative step,” Michael Woolfolk, senior currency strategist at the Bank of New York-Mellon Corp. (BK), told Reuters. “We think it's the best possible move for the U.S. consumer and for the financial market.”

The rate cut announcement dropped onto a cushion of ugly headlines from earlier in the day:

• Consumer prices posted their biggest plunge in 76 years. The U.S. consumer price index (CPI) fell by a seasonally adjusted 1.7%, lead by a 17% decline in energy prices, the Labor Department reported. On a non-seasonally adjusted basis, the CPI fell by 1.9%, the biggest decline since 1932, three years into the Great Depression.
• Yields for 30-year Treasuries fell to an all-time low, Bloomberg News reported.
• Goldman Sachs Group Inc. (GS) reported a loss of $2.12 billion, or $4.97 a share, for its fiscal fourth quarter.
• New building permits and new housing starts hit a record low in November, as permits plummeted 15.6% to 616,000 units from 730,000 in October. Housing starts fell 18.9% to 625,000 from 771,000 in October, Reuters reported.

Joel Naroff, president and chief economist of Naroff Economic Advisors, doesn’t expect the rate cut to do much because banks simply don’t want to lend.

“There is little belief that will do anything as the issue is not the level of rates but the willingness to lend.  It may put a little more pressure on other central banks to ease, especially the Europeans,” Naroff wrote in a note to clients. “But other than that and the reduction in some variable-rate loans tied to the prime, the rate cut will not accomplish a whole lot.”

He added: “With the rate near zero, the Fed is basically out of bullets when it comes to the rate cut weapon so we will see what they say about using other mechanisms to add liquidity.” 

Money Morning contributing editor Martin Hutchinson said in a recent column that the Fed’s rate cuts – combined with the government’s $700 billion bailout – will push so much money into the financial system that the final result will be widespread inflation – which is essentially an open invitation to profit from gold.

What Else Can the Fed Do?

With little to no room left to cut rates, Fed Chairman Ben S. Bernanke has signaled that he may employ unconventional ways to restore balance to the U.S. financial system.

The Fed extended the lives of recently initiated programs (lending facilities for investment firms, for instance) and is exploring additional moves (like Treasury purchases) aimed at reviving the credit markets. 

Meanwhile, the U.S. Treasury Department is working on a plan to rejuvenate the housing market by slashing mortgage rates to 4.5% on new purchases. Experts say that, at some point, these stimuli must take hold, but that’s not necessarily true.

Many of Bernanke’s plans may be an afterthought on Jan. 20, when President-elect Barack Obama takes office with a different economic team and agenda.

New York Federal Reserve Bank President Timothy F. Geithner will be the new administration’s U.S. Treasury secretary, a role that will give Geithner the reins to what’s left of the Bush administration’s $700 billion bailout.

Former Treasury chief Lawrence Summers will head Obama’s National Economic Council. Analysts say this appointment puts Summers in line to succeed Ben S. Bernanke as chairman of the U.S. Federal Reserve in 2010. 

New Mexico Gov. Bill Richardson will take over the Commerce Department, and Congressional Budget Office Director Peter Orszag will head the Office of Management and Budget.

News and Related Story Links:

• Reuters:
  Fed cuts rates to the bone

• Bloomberg:
  U.S. Treasury 30-Year Bond Yields Fall to Record Low Before Fed

• Money Morning:
  Fed Looking at Another Rate Cut, While Treasury Has New Plan for Housing