ECONOMICS AND TRADE | Achieving growth through open markets
31 October 2008
Central Bank Aims to Prevent Financial Downturn from Worsening
Federal Reserve collaborates with foreign counterparts to calm turmoil
Washington — The U.S. central bank’s push to restore the circulation of credit in the economy and calm currency markets is likely to mitigate an economic downturn in the United States and around the world, analysts say.
On October 29, the Federal Reserve, the U.S. central bank, lowered its benchmark interest rate by 0.5 percentage point to 1 percent, barely two weeks after a previous cut. This move was accompanied by similar measures in China, Norway and several other countries. The European Central Bank and Bank of England are likely to follow suit in the week of November 3.
Analysts believe extraordinary collaboration among central banks has been prompted by the gravity of the financial problems, uncertainty about their consequences and their global scale.
U.S. monetary policymakers made clear in an October 29 statement the economic slowdown is serious and they view the situation as likely to deteriorate.
A day later, the Commerce Department reported that the U.S. economy contracted by 0.3 percentage points in the third quarter and that consumer spending fell for the first time since the recession of 1991.
The new strike at the global economic downturn by central banks followed an unusual, coordinated rate-cutting action by several major countries October 8. By pushing their key interest rates down, monetary authorities reduce the cost of funds for banks, thus encouraging more lending.
Some U.S. banks responded to the Federal Reserve’s newest move by lowering prime lending rates by a corresponding half-percentage point. Short-term credit has begun flowing slowly to corporations. But many lenders remain cautious, and interest rates on some types of credit, such as home mortgages, after some jumps up and down, have returned to the level of the summer.
Economists state that it takes 6 to 18 months for rate reductions to produce demonstrable effects. Therefore, a series of consecutive rate cuts initiated by the Federal Reserve in September 2007 may not yet have worked its way through the economic system. Those cuts, however, have signaled to market participants that the Federal Reserve is determined to use this policy tool aggressively, said Edwin Truman, a former Federal Reserve official and now a fellow at the Peterson Institute for International Economics.
“If they hadn’t started lowering rates a year ago, we would have been in a much bigger mess today,” he told America.gov.
Allen Berger, a professor in banking and finance at the University of South Carolina and a former Federal Reserve economist, agrees. So far, those measures combined with the stimulus package have prevented the economy from entering a deep recession, he told America.gov.
Some economists worry that, with the key interest rate — the rate banks charge each other for overnight loans — at 1 percent, the U.S. central bank has little room left to cushion the downturn.
According to Truman, Federal Reserve Chairman Ben Bernanke expressed tentative support for a new economic stimulus package because he sees little maneuvering room on the rates. (See “Congressional Democrats Push for Economic Stimulus.”)
Pushing the rate down to zero would eliminate an important policy tool from the central bank’s toolbox and, if the economy continues to contract, force it to use more unorthodox and untested measures such as pushing down rates on government bonds of longer maturities or buying foreign-government debt.
Berger said this scenario is unlikely. He predicts the central bank will continue lending directly to banks and businesses as part of its commercial paper program and possibly will devise other programs to pump money into the economy.
THE FED DEALS WITH GLOBAL TURMOIL
In another action, the Federal Reserve moved to prop up some emerging market economies with $120 billion in direct loans to their central banks; such loans are known as currency-swap arrangements. The step is designed to help Mexico, Brazil, Singapore and South Korea defend their beleaguered currencies and credit markets. In recent weeks, economies that only months ago were thought to be insulated from the financial turmoil have come under increasing pressure as investors have fled to seek a safe haven in the U.S. dollar and U.S. Treasury bonds, which are considered the safest investment in the world.
Earlier in the year, the U.S. central bank entered into currency-swap arrangements with central banks of several developed nations. So far, the Federal Reserve has made more than $400 billion available to other central banks.
The International Monetary Fund (IMF) announced October 29 its own $100 billion lending program designed to provide short-term loans to countries affected by the financial downturn. The new three-month loans will be available to distressed — but fundamentally sound — economies and will have fewer strings attached than traditional IMF loans have had.
To learn more about Federal Reserve policy options see November 21, 2002, remarks by then-governor of its governing board Bernanke on the Federal Reserve Web site.
