Fed slashes key rate to near zero

NEW YORK (CNNMoney.com) -- In its latest effort to try and stimulate the U.S. economy, the Federal Reserve cut its key interest rate to a range of between zero percent and 0.25%, and said it expects to keep rates near that unprecedented low level for some time to come.

The central bank typically sets a specific target for its federal funds rate instead of a range. The rate had previously been at 1% and this marks the first time the Fed has cut rates below 1%. Most investors were expecting the Fed to cut rates to either 0.25% or 0.5%.

The federal funds rate is an overnight lending rate used as a benchmark to set rates for a variety of loans, including adjustable rate mortgages, credit cards, home equity lines of credit and business loans. This marks the tenth time it has cut rates in the last 15 months.

Several banks announced they were lowering their prime rate to 3.25% in light of the Fed's decision. Typically, the prime rate is 3 percentage points higher than the fed funds rate. It was 4% before Tuesday's rate cut.

Despite the dramatic nature of the Fed's move, some economists questioned whether it will have much effect on the economy. They said the problem for consumers and businesses right now is not the cost of borrowing, but the availability of credit and the weaker economic fundamentals.

"Lowering rates to this level is purely a psychological move made to send the message that the Fed is committed to righting the sinking economic ship," said Rich Yamarone, director of economic research at Argus Research. He noted the previous rate cuts did little to stop home and auto sales from plunging.

Running out of arrows

There are some concerns that taking the fed funds rate so close to zero leaves the Fed with little room for additional moves if the economy does not start to show signs of improvement soon.

But the Fed said in a statement that it is looking at different steps it can take to stimulate the economy and keep market rates low, including the purchases of long-term U.S. Treasury notes. The Fed also said it will consider other, yet to be disclosed moves as well.

"The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity," the Fed said.

A senior Fed official who briefed reporters after the announcement said the Fed set a range for the rate rather than give a specific number as an acknowledgement that it has trouble precisely controlling the rate at a time when rates are this low.

The effective rate, which is based on market trades of Treasurys and excess reserve balances between banks on a daily basis, has been regularly slipping below the Fed's stated rate for a couple of months now.

Asked why the Fed didn't go ahead and the cut the rate to 0%, the Fed official said keeping the rate a little above zero would make the credit markets run more smoothly.

John Silvia, chief economist at Wachovia, said he thinks the said it is possible that the effective fed funds rate could even fall below zero on occasion and the Fed can "live with that" because the central bank is "going to do whatever it takes" to prevent the economy from deteriorating further.

Kevin Giddis, managing director of fixed income at Morgan Keegan, said he was surprised by the move. Like many investors, he had expected that the Fed would only cut the rate to 0.5%.

"I didn't think they would be this aggressive. I thought they'd keep something left in the quiver," he said.

Worries about deflation

In explaining the reason behind the rate cut, the Fed said the U.S. economy, which has officially been in a recession for a year, was in danger of getting weaker, and that the risk of inflation had decreased "appreciably."

Earlier Tuesday, the Labor Department reported that the Consumer Price Index, its key inflation measure, fell by a record 1.7% in November. In fact, some economists are growing more worried about deflation.

One economist pointed out that there was a notable change between Tuesday's statement and the one it issued when it last cut rates in October that suggested to him the Fed is concerned about deflation, the phenomenon of drastically lower prices that can hurt the economy.

In October, the Fed said it expected inflation would drop "to levels consistent with price stability." On Tuesday, those five words were not in the statement and the Fed just said it expects inflation to "moderate further."

"To me, they're looking at deflation now," said Jeoff Hall, the chief U.S. economist for Thomson Reuters-IFR Markets. "There's no looking back at inflation."

The senior Fed official said, however, that deflation is not a major concern of the Fed. But the official said the Fed would continue to monitor prices and respond as necessary.

Typically, the Fed raises rates to fight inflation and lowers them to encourage spending my making borrowing more affordable. The central bank has dual goals of promoting economic growth and price stability.

Other central banks, notably the Bank of Japan, have taken interest rates down to near the 0% level in the past. Last week, the Swiss central bank cut its key lending rate to 0.5%. To top of page

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