This article first appeared in the St Louis Beacon, Dec. 17, 2008 - The Federal Reserve's decision to cut an important interest rate to a record low of 0.25 percent begs the question: What's next? Goose eggs?
The Fed vowed Tuesday that it would take aggressive action in the face of the worsening recession, including cutting its target interest rate of 1 percent by three-quarters. The interest rate is an overnight bank lending rate known as the federal funds rate. In a statement released at the conclusion of a two-day meeting, the Fed also said that interest rates would remain low "for some time" and that it would consider other efforts to boost the economy, such as the purchase of U.S. Treasury bonds.
Just what is the Fed thinking these days -– and should we be worried?
Long Chen, an associate professor of finance at Washington University's Olin School of Business, said the action is a sign that the Fed is concerned enough about deflation to take drastic action.
Chen said that, essentially, the federal funds rate is a short-term market rate between banks. It stems from a requirement that depositor institutions, such as banks, must "reserve" 10 percent of their money with the Federal Reserve Bank, where it is held against specified deposit liabilities. The banks borrow and lend from one another overnight at the federal funds rate to satisfy that requirement.
The Fed doesn't actually set the federal funds rate; it sets a target for the rate. And it is helpful to know that the target rate was, in effect, already at about 0.25 percent, Chen said.
"So the market fully expected this cut -- we were already there. What the Fed does is basically announce this for a philosophical effect," he said. "It shows the Fed's commitment to further lower the rate and to battle deflation."
The Fed's action came on the same day that the U.S. Labor Department reported that consumer prices fell 1.7 percent in November, the second record decline in two months. In addition, the Commerce Department reported that construction of new homes fell by 18.9 percent in November, the biggest drop in 25 years. While falling prices may sound good to consumers, the effect on retailers and manufacturers can be disastrous in an already troubled economy.
"What deflation means is there is no demand for consumption. Nobody wants to buy stuff, so the price of everything keeps on dropping. The bad thing is the companies see prices have to drop, so they will lay off people and further shrink demand," Chen said.
Lowering the target interest rate is a tool used to increase the money supply, which is necessary in an economy that is facing pressure from deflation, Chen said.
Could the Fed set the target interest rate at zero? In a word: Yes.
"Zero percent is not unprecedented, and it can happen," Chen said. "Deflation is a big problem."
Chen pointed out that other nations have seen zero rates. In the 1990s, for example, Japan's central bank cut interest rates to zero during what was a very long and painful recession. A zero rate would signal the end of the road for one of the Fed's most important monetary policy tools. That's why the Fed vowed to use other aggressive and unconventional actions, such as the purchase of Treasury bonds to increase money supply.
And remember, Chen said, this bargain basement interest rate is limited to overnight loans between banks, a not-too-risky venture. Businesses and consumers won't be finding 0.25 percent interest rates on car loans and home mortgages. The bank prime rate -– the rate charged the most credit-worthy customers -– is 4 percent.
During the economic turmoil that followed the terrorist attacks on Sept. 11, 2001, then-Fed chairman Alan Greenspan cut the target interest rate to 1 percent to fend off a fear of deflation, Chen said.
"That boosted the residential housing market, and that carried the economy out of recession and sowed the seeds for the housing bubble," Chen said.
That bubble is at the root of the current recession, which he believes is just now showing its effects.
"The conventional wisdom is if a recession is triggered by the financial markets it will last longer. In the post-war period, recessions have lasted an average of two to three quarters; we have been good at managing recessions," Chen said. "This time, the recession was triggered by the financial markets, and capitalism is built on the credit markets. The engine stopped. The last time we had a huge financial market crash, it was the Great Depression."
The decision by Fed chairman Ben Bernanke and U.S. Treasury Secretary Henry Paulson to bail out the financial markets was driven by that economic experience, Chen said.
"Bernanke is a student of the Great Depression. He knows if the financial markets trigger a breakdown what's going to happen. It's the reason those guys seemed to abandon the principles of capitalism -- because they were seeing the bigger risk ahead. We're starting to see this. The whole credit market has been clobbered, and we see the layoffs and problems," he said.
Chen doesn't believe the current recession will approach the depths of the Great Depression because, he said, economists and policy-makers "know more today." The Fed is studying new tools, such as its recently announced program to purchase $600 billion of troubled mortgages from Fannie Mae and Freddie Mac.
"The government says, 'If people don't want to lend, we're going to lend to you directly. If people don't want to borrow, we'll borrow the money to spend on projects to stimulate the economy," Chen said.
He believes the key is the housing market, which is still bottoming out.
"When you are in a recession, you don't see the bright light, but it will come around," Chen said. "The trigger is the housing market. When we see the bottom of the housing market, when we see foreclosures stabilized. That will be the turning point."
defined
Federal funds rate: The interest rate at which a depository institution (such as a bank) lends immediately available funds (balances held at the Federal Reserve) to another depository institution overnight. The Federal Open Marketing Committee, the branch of the Fed that determines the direction of monetary policy, sets a target for this rate but not the actual rate itself, which is determined by the open market. The committee meets eight times a year to increase or decrease the money supply and set key interest rates.The meetings are secret but always carefully watched by Wall Street.
Source: Investopedia.com, a Forbes digital company
