Tuesday, December 16, 2008

Fed cuts benchmark interest rate to nearly zero

The Federal Reserve has cut the benchmark interest rate to nearly zero. From The New York Times.

This is a first for the Federal Reserve. From The New York Times:

WASHINGTON — The Federal Reserve entered a new era on Tuesday, setting its benchmark interest rate so low that it will have to reach for new and untested tools in fighting both the recession and downward pressure on consumer prices.

Going further than analysts anticipated, the central bank said it had cut its target for the overnight federal funds rate to a range of zero to 0.25 percent, a record low, bringing the United States to the zero-rate policies that Japan used for six years in its own fight against deflation.

The move to a zero rate, which affects how much banks charge when they lend their reserves to each other, is to some degree symbolic. Though the Fed’s target had had previously been 1 percent, demand for interbank lending has been so low that the actual Fed funds rate has hovering just above zero for the past month.

Far more important than the rate itself, the Fed bluntly declared that it was ready to move to a new phase of monetary policy in which it prints vast amounts of money for a wide array of lending programs aimed at financial institutions, businesses and consumers.

“The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” the central bank said in its statement. Those tools include buying of “large quantities” of debt and mortgage-backed securities and debt issued by government-sponsored companies like Fannie Mae; commercial debt for businesses and consumer lending, and longer-term Treasury securities.

The problem I see here is that even though the Feds have cut their lending rate, to the banks, to almost zero, the banks are still not giving out loans to consumers or businesses. The banks are still saddled with bad debt from the collapsed housing market, and the soured derivative schemes that were backed by the subprime mortgages. Furthermore, the banks are getting stuck with a lot of foreclosed homes that they can't sell to cover their losses. The U.S. Treasury has given over $700 billion to Wall Street in an effort to free up the frozen credit market, however the banks are using this money to cover their own balance sheet losses, or to purchase other banks, rather than lend this money out as the U.S. Treasury had originally planned. Now we have the Federal Reserve both lowering the interest rate to almost zero, but also planning to print even greater amounts of money to dump into the market in the purchase of mortgage-backed securities and even more debt. The bottleneck here is that the banks, and Wall Street, is really hoarding all this federal money:

Ben S. Bernanke, the chairman of the Federal Reserve, has already outlined a range of unorthodox new tools that the central bank can use to keep stimulating the economy once the federal funds rate effectively reaches zero.

Those techniques include buying vast amounts of longer-term Treasury bonds, mortgage-backed securities issued by government-sponsored companies like Fannie Mae and Freddie Mac and commercial debt issued by private companies and consumer lenders.

The Federal Reserve has already introduced a slew of lending programs in its effort to revive corporate and consumer lending. Later this month, the Fed will start purchasing $600 billion worth of securities that are backed by Fannie Mae, Freddie Mac and other government-sponsored entities. The Fed and the Treasury are also introducing a joint program to buy up securities backed by consumer debt like automobile loans.

All of the new tools amount to printing money in vast new quantities, and the Fed has already started the process. Since September, the Fed’s balance sheet has ballooned from about $900 billion to more than $2 trillion as the central bank has created new money and lent it out through all its new programs. As soon as the Fed completes its plans to buy up mortgage-backed debt and consumer debt, the balance sheet will be up to about $3 trillion.

“At some point, and without knowing the timing, the Fed is going to have to destroy all that money it is creating,” said Alan Blinder, a professor of economics at Princeton and a former vice chairman of the Federal Reserve, said the central bank. “Right now, the crisis is created by the huge demand by banks for hoarding cash. The Fed is providing cash, and the banks want to hoard it. When things start returning to normal, the banks will want to start lending it out. If that much money is left in the monetary base, it would be extremely inflationary.”

The U.S. economy is straddling a razor's edge between deflation and inflation. And it all depends on when the banks want to start lending money out in the credit markets. However, the banks are afraid of lending money out because of all the losses they still have on their balance sheets due to the subprime mortgage collapse. The banks would love to have the U.S. taxpayer bail them out without any strings attached. And the U.S. Treasury, and the Federal Reserve, are willing to oblige. The U.S. economy could quickly go from a period of possible deflation to an extreme inflationary period. It all depends on when the banks are willing to lend.

And the Federal Reserve has shot its final interest-rate bolt from its quiver.

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