Fed Cuts Rate to as Low as Zero, Will Use All Tools

By Scott Lanman and Craig Torres

Dec. 16 (Bloomberg) — The Federal Reserve cut the main U.S. interest rate to as low as zero and said it will buy debt as the next step in combating the longest recession in a quarter-century and reviving credit.

The Fed “will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” the Federal Open Market Committee said today in a statement in Washington. “Weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

Treasury notes rallied in anticipation the Fed will buy the securities to force borrowing costs for consumers and companies lower. Nine rate cuts in the prior 14 months and $1.4 trillion in emergency lending failed to reverse the economic downturn. Today, the Fed said it will target a federal funds rate of between zero and 0.25 percent.

“The focus of the committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level,” the FOMC said.

The dollar tumbled against the euro and yen. Stocks climbed, pushing the Dow Jones Industrial Average up 216 points, or 2.6 percent, to 8797.12 at 2:53 p.m.

Printing Money

“The Fed is sending a message that it will print money to an unlimited extent until it starts to see the economy expanding,” William Poole, former president of the St. Louis Fed and now a senior fellow at the Cato Institute in Washington, said in an interview with Bloomberg Television. Poole is also a contributor to Bloomberg News.

The statement noted that the Fed has already announced it will purchase the debt issued or backed by government-chartered housing finance companies, and said the Fed is ready to expand the program. The central bank said it continues to weigh the potential benefits of buying longer-term Treasury securities.

The deepening economic slump pushed unemployment to 6.7 percent last month, the highest level since 1993, while builders broke ground on the fewest new homes since record-keeping began in 1947. Deflation is also emerging as a risk: consumer prices fell the most on record in November, the Labor Department said earlier today.

No Dissent

Today’s vote was unanimous. In a related move, the Fed lowered the rate on direct loans to banks and securities dealers to 0.5 percent. It set the payment on the reserves that commercial banks hold at the Fed at 0.25 percent, down from 1 percent.

Fed policy makers twice pared the federal funds rate, or overnight lending rate, to 1 percent since adopting it as the main tool of monetary policy in the late 1980s. The 1 percent rate held from June 2003 to June 2004, and again from the end of October to today.

The Bank of Japan has been the only major central bank in modern times to mix a policy of steep rate reductions with quantitative easing, or the strategy of injecting more reserves into the banking system than needed to keep the target rate at zero.

Japan’s central bank kept its main rate at zero from 2001 to 2006 while flooding the banking system with extra cash to encourage lending, spur growth and overcome deflation. The abundant funds failed to prompt lending by commercial banks, which expanded their reserves at the central bank almost nine times by early 2004.

Emergency Loans

Bernanke, acting with New York Fed President Timothy Geithner, has set up emergency loan programs aimed at averting a collapse of the nation’s credit markets. Geithner is President- elect Barack Obama’s pick for Treasury secretary and didn’t attend today’s meeting.

The Fed has enlarged bank reserves, supported issuance of commercial paper and provided liquidity to government bond dealers. It is also swapping dollars with the European Central Bank and its other counterparts to supply banks in other countries.

The moves have swelled the Fed’s balance sheet to $2.26 trillion from $868 billion in July 2007. That’s in addition to the $700 billion Troubled Asset Relief Program, which the U.S. Treasury has used since October to channel about $335 billion of capital injections into banks and other financial companies.

Still, the economy has crumbled, with employers cutting 533,000 jobs from payrolls in November for a total loss this year of 1.9 million, which more than erases the 2007 gain of 1.1 million.

Credit remains scarce in many markets and major financial institutions worldwide continue to report losses and writedowns totaling $994 billion.

Shrinking Economy

Macroeconomic Advisers LLC, a St. Louis-based consultant, says the economy is probably shrinking at a 6.5 percent annual pace this quarter, which would be the biggest drop since 1980.

The firm forecasts a 4.2 percent annual contraction rate in the first quarter, returning to no growth in the second quarter and a 2.3 percent expansion rate in the second half of 2009.

Early this month, as a panel of leading U.S. economists declared the recession began in December 2007, Bernanke signaled he was ready to dig deeper into the central bank’s toolkit. He said he may use less conventional policies, such as buying Treasury securities, because his room to lower the main U.S. rate from the current 1 percent level was “obviously limited.”

Fading Relevance

The federal funds target rate has weakened as a monetary policy tool because the Fed’s flood of funds has caused the average daily rate to trade below the policy goal every day since Oct. 10.

The gap between the target and the effective rate, or average daily market rate, has averaged about a half point since Sept. 12. The gap averaged just above zero from the start of this year through Sept. 2.

The central bank is trying to lower mortgage rates by purchasing up to $100 billion of debt issued by housing-finance providers Fannie Mae and Freddie Mac and $500 billion of mortgage-backed securities guaranteed by the companies.

The Fed’s counterparts around the world have staged their own interest-rate cuts. The ECB has lowered its main rate to 2.5 percent this month from 4.25 percent in July, while the Bank of England reduced its rate to 2 percent this month from 5.75 percent in July.

ECB President Jean-Claude Trichet said yesterday there’s a limit to how far the bank can cut interest rates and signaled policy makers may pause in January. “Do we have a feeling there is a limit to the decrease in rates? At this stage certainly yes,” Trichet told journalists in Frankfurt.

While the Fed can’t push interest rates below zero, “the second arrow in the Federal Reserve’s quiver — the provision of liquidity — remains effective,” Bernanke said in a Dec. 1 speech.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net; Craig Torres in Washington at ctorres3@bloomberg.net;

Last Updated: December 16, 2008 15:15 EST