Fed cuts short-term rates to the bone

The Federal Reserve slashed short-term interest rates today to nearly zero, bringing to an end a 15-month campaign of rate reductions intended to encourage borrowing and stimulate economic growth.

With further cuts no longer possible, members of the Fed's open market committee promised to continue to "employ all available tools" to support financial markets and stimulate the economy, including purchases of mortgage-backed securities and other debt.

In cutting the target for the federal funds overnight rate to a never-before-seen low -- between zero and 0.25 percent -- the committee acknowledged that as weak as the economy is, it's likely to stay at "exceptionally low levels ... for some time."

The committee also cut the discount rate -- the rate the Fed charges banks for short-term loans -- from 1.25 percent to 0.5 percent.

Today's action was the last of 10 reductions in the federal funds rate intended to stimulate economic growth. Before the cuts began in September 2007, the federal funds rate stood at 5.25 percent.

While some critics of the Fed's monetary policy worried that slashing interest rates would spark inflation and devalue the dollar, those concerns were overridden by the worsening financial crisis and its impact on the economy. In understated fashion, the Fed's open market committee noted in a statement that "inflationary pressures have diminished appreciably."

The Department of Labor today reported that the U.S. consumer price index fell by a seasonally adjusted 1.7 percent in November, the biggest drop since 1947. Falling energy prices, especially gasoline, drove the decline -- the index was virtually unchanged when energy prices were excluded.

Although the Fed can no longer make money available more cheaply, it can still provide liquidity through "quantitative easing" -- debt purchases that will further swell the Fed's $2 trillion balance sheet.

In coming quarters, the Fed will purchase "large quantities" of debt and mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae to provide support to the mortgage and housing markets, the committee said.

The announcement of that program helped bring mortgage rates down by 1 percent (see story), and the Fed stands ready to expand its purchases of agency debt and mortgage-backed securities "as conditions warrant."

Early next year, the Federal Reserve will launch the $200 billion Term Asset-Backed Securities Loan Facility (TALF) initiative to encourage lending to households and small businesses. The Fed is also evaluating the potential benefits of purchasing longer-term Treasury securities, and will continue to consider ways of using its balance sheet to further support credit markets and economic activity, the committee said.

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