ECONOMICS AND TRADE | Achieving growth through open markets
16 December 2008
U.S. Federal Reserve Cuts Interest Rates to Historic Low
U.S. central bank decision aimed at reassuring market, stimulating economy
Washington — The U.S. central bank on December 16 cut interest rates to an all-time low, a move aimed at reassuring financial markets and stimulating banks to lend money.
The Federal Reserve Board lowered the target federal funds rate to a range of 0 percent to 0.25 percent, the lowest level in the history of modern monetary policy. The federal funds rate is the rate at which banks lend to one another. The rate, historically, has an effect on the rates consumers are charged for home mortgage loans and other types of credit.
“Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined,” the Federal Open Market Committee said in a statement announcing the move. “Overall, the outlook for economic activity has weakened further.”
A Fed interest rate cut in October failed to stimulate as much lending as regulators and policymakers wanted to see. “Financial markets remain quite strained and credit conditions tight,” the committee said.
Banks have stockpiled enough reserves — $700 billion — to finance loans, but the financial turmoil has made them nervous about being repaid, said Richard Sylla, co-author of The History of Interest Rates and a professor of financial history at New York University.
“The economic significance of cutting the fed funds rate … is not as big,” Sylla told America.gov. “It's more of a psychological move to show the market the Fed is still there and still willing to do whatever it takes.”
A cut in the Fed's target rate lowers the interest rates consumers and businesses pay, making it more appealing for them to borrow money. When they spend that loaned cash, it boosts the economy by increasing the demand for goods, services and labor.
“Then firms can spend more, and that would boost hiring, or in this case, mean less firing,” said Allen Berger, Osteen professor in banking and finance at the University of South Carolina and a former Federal Reserve economist.
A Fed rate cut generally takes six months to nine months to fully work its way through the economy, Berger told America.gov.
The current situation is unusual because interest rate cuts alone are not prompting increased bank lending.
“The problems of the economy are severe, and they're mostly related to the availability of credit as opposed to the cost of credit,” said David Cross, president of Market Outlook, an economic research and forecasting company. “The Fed can't force the banks to lend.”
In addition to the rate cut, the Federal Reserve plans to use nontraditional methods to encourage activity in credit markets, such as buying mortgage-backed securities, debt from mortgage giants Fannie Mae and Freddie Mac, corporate bonds and long-term Treasury securities.
“The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” the committee said in its statement.
“Essentially, they are going out and buying assets with money they've created,” said Gus Faucher, director of macroeconomics at Moody's Economy.com, an economic analysis and forecasting company.
The most significant proposal on the table is for the Fed to buy enough housing debt to force mortgage rates down to 4.5 percent and revitalize the real estate market, Cross said.
According to the Mortgage Bankers Association, interest rates for 30-year-fixed-rate mortgages are between 5 percent and 5.25 percent. That range is down roughly 1 percentage point from the levels just three weeks ago, before the Fed announced its plan to invest in the mortgages held by Fannie Mae and Freddie Mac.
“The combination of lower rates and increased liquidity should be enough eventually to turn things around,” Faucher said.
Around the world, central banks have reduced interest rates to stimulate their own economies and avoid a prolonged global recession.
“We do have expectations for most central banks to be cutting rates over the next year or so because of the slowing in the global economy,” Faucher said.
