Rates down to near-zero; Fed may underwrite loans, keep buying assets from markets
By VIKRAM KHANNA
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(SINGAPORE) In a radical and historic step, the US Federal Reserve on Tuesday slashed its benchmark Fed funds rates to near-zero and pledged to use 'all available tools' to deal with a deepening recession, including aggressively pumping money into the economy.
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The Fed lowered its target for the Fed funds rate to a record low of zero to 0.25 per cent, from one per cent, and signalled its readiness to keep rates low for an extended period.
The US economy is reeling from a year-long recession that many fear could prove to be the worst since the 1930s.
With recent data pointing to a deepening contraction and intensifying deflationary pressures, the Fed clearly felt the need to pull out all the stops.
However, in part, its rate cut was but an acknowledgment of market reality: The Fed funds rate - what banks charge one another for overnight loans - has been already below 0.5 per cent in recent weeks.
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With the cut, the Fed has all but exhausted its conventional tools for managing the economy. However, it signalled that it would accelerate its policy of 'quantitative easing' - essentially pumping money into the economy by purchasing a variety of financial assets from the markets.
It has already been doing this since the collapse of the investment bank Bear Stearns in March, and has intensified the process since the bankruptcy of Lehman Brothers in mid-September.
Over the last three months, the assets on the Fed's balance sheet have soared to US$2.2 trillion, from US$887 billion. Some analysts think that the total could eventually top US$3 trillion.
In its statement on Tuesday, the Fed said that it 'stands ready' to expand purchases of mortgage-related securities; it announced plans to buy US$600 billion of these last month, which helped drive US mortgage rates down by half a percentage point.
The Fed also said that it was looking into purchasing longer-term Treasury bonds, which drove the rates on 10-year Treasuries down by 0.2 of a percentage point in trading on Tuesday.
In addition, it signalled its intention to underwrite credit card loans, car loans, student loans and small business loans.
'The Fed has realised that there is one entity left to bring the financial system in line,' said Jessica Hoversen, fixed income market analyst at MF Global Research in Chicago.
'It has to be the Atlas of the world to bear the weight of the financial system on its shoulders.'
In poker terms, 'the Fed went all in,' said Paul McCulley, a managing director at bond-fund giant Pimco in Newport Beach, California. 'It was exactly what they needed to do.'
'The Fed made it very clear it is committed, without limits, to avoiding a depression,' said David Kotok, head of money manager Cumberland Advisors in Vineland, New Jersey.
'This is a tremendously bullish move for all 'risk' assets', including stocks and bonds, he said.
The Fed's policy of quantitative easing is similar to the policy pursued by the Bank of Japan since 2001 to expand the money supply after having slashed interest rates to zero. However, a senior Fed official, in a conference call with reporters on Tuesday, made a distinction between the Fed's actions and the Japanese model.
Rather than trying to boost its balance sheet as an end in itself, the Fed is making loans to improve mortgage and credit market conditions - which happen to have the effect of expanding its balance sheet, the official said.
In other words, whereas Japan flooded the banking system with funds, the Fed is focusing on bypassing lending-wary banks and targeting specific markets that are starved of credit.
As Julia Coronado, senior US economist at Barclay's Capital, explained: 'The Fed is now focused on getting credit to businesses and consumers rather than just pumping money into the economy in a passive way.'
The Fed official also pointed out that the US central bank's shift towards quantitative easing after slashing rates to near-zero would change the way the Fed's future actions is viewed and interpreted. In the past, people wanting to understand the Fed's policies would look to its decisions on the Fed funds rate and the accompanying statement. But with the rate now stuck near zero for the foreseeable future, Fed watchers will instead be tracking which lending programmes the Fed is creating or expanding, he said.
The Fed's rate cut and statement were approved unanimously by the Fed's policymaking committee, including by the so-called 'inflation hawks' who had opposed aggressive rate cuts and unconventional monetary policies earlier.
'I think the situation is so dire that everyone was of the same opinion that we need to put out the big fire first and then worry about the rest,' said Sung Won Sohn, an economist at California State University. -- With contributions from agency reports
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