Fed Cuts Rates to Historic Low (Wall Street Journal)

By JON HILSENRATH

The Federal Reserve slashed its target interest rate to a range just above zero and promised to march ahead with unconventional measures to combat a recession that has deepened in the past few weeks.

The Fed said it would keep its target interest rate -- an overnight bank lending rate called the federal funds rate --- between zero and a quarter percentage point after having moved it to 1% in October. The cut was more than many economists expected and marked the latest signal by the Fed and its chairman, Ben Bernanke, that the central bank was prepared to take aggressive steps to revive the economy and financial markets.

"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability," the Fed said in a statement. It added that it expected interest rates to remain low "for some time" and that it was studying other measures, such as purchasing U.S. Treasury securities, to lift the economy.

In the latest example of the deepening recession, the Commerce Department reported that new homebuilding dropped 19% in November alone, to a seasonally adjusted annual rate of 625,000 units, a record monthly low.

Meanwhile, consumer prices posted their second straight record monthly drop. Gasoline prices tumbled while car dealers, retailers and others stepped up discounting to move goods and services.

Other official borrowing rates -- such as rates on 3-month Treasury bills -- also have tumbled to near zero, a level they haven't been near since the 1930s. The trouble for Fed officials is that while official borrowing rates are very low, interest rates for borrowers with even a modicum of risk remain far above levels of a few months ago, which is squeezing the economy.

Officials spent much of two days of meetings deliberating over what else the central bank can do to control a worsening crisis. With interest rates near zero, there isn't much more the Fed can do with this traditional lever.

The Fed has already started an aggressive campaign to lend directly to damaged financial markets and companies -- almost anyone with collateral. Its statement Tuesday came with a promise to extend those efforts.

"The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level," the Fed said.

Two large Fed lending programs are still being ramped up. In one, the central bank will buy up to $600 billion of debt issued or guaranteed by Fannie Mae, Freddie Mac and other government-backed mortgage businesses.

So far, the Fed has only committed $8 billion to those purchases. Officials have been relieved that mortgage rates have come down since announcing the program. Rates on a conforming 30-year mortgages have dropped from 6.64% to 5.28% since the Fed's last meeting, according to HSH Associates, a financial publishing firm. It has been one of the few areas in financial markets where credit costs have shown substantial improvement in the past few weeks.

"Over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant," the Fed said.

Fed officials have high expectations for a separate program through which they will lend up to $200 billion against high-rated securities backed by car loans, student loans, credit-card debt and small-business loans.

U.S. officials have said the program, which is called the Term Asset-Backed Securities Loan Facility and is expected to be operational in February, can be expanded to other asset classes -- such as commercial real estate loans or mortgages not backed by Fannie and Freddie.

The program could be expanded in other ways if it works. For instance, right now it is geared toward newly issued securities. But it is feasible the Fed could also use it to backstop previously issued securities to help banks clear room on their balance sheets.

Fed officials believe the economy would be in much worse shape had they not already moved aggressively to lower interest rates and expand their lending facilities. Increasingly, however, the economic backdrop is looking to be grim even with the medicine.

"The Fed gets an 'A' or 'A-minus' for effort and not very good marks for results," said Alan Blinder, a Princeton economic and former Fed vice chairman.

The Federal Open Market Committee had downgraded its unemployment and economic growth projections at its last meeting on October 29 and things have only gotten worse since then. The unemployment rate, at 6.7% in November, was already above the Fed's October forecast for the fourth quarter and looks sure to go higher still.

Economists at Macroeconomic Advisers LLC, a forecasting firm, say the nation's gross domestic product is on track to contract by 6.5% in the current quarter. If they're right, it will be the worst quarter since 1980.

"Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight," the Fed said.

The latest housing data underscored the grim economic setting. The housing downturn is now more than three years old. "November's report for new home production and permit issuance indicates not only that conditions aren't improving in the housing market, but that the situation is getting worse," said David Crowe, chief economist with the National Association of Home Builders.

The recent decline in mortgage rates could help. Fed officials also are focused on reducing other rates relative to Treasury benchmarks, a difference that is known on Wall Street as a 'spread.' Across a wide-range of lending, spreads have remained painfully high since September, a sign of tight credit conditions.

One closely followed spread is the difference between interbank lending rates over three months and the expected federal funds rate -- a measure of banks' unwillingness to lend to each other. That spread has come down from more than three percentage points in early October to about 1.5 percentage points, but it remains well above levels that prevailed earlier this year.

Other spreads have continued to march higher. For instance, 'BB'-rated junk bonds now trade at more than 14 percentage points above comparable Treasury bonds -- a crushing borrowing cost for many low-rated companies -- compared to a spread of less than six percentage points before September.