How low can Fed go on interest rates?
By JEANNINE AVERSA
10.30.08

Washington - Just how far will the Federal Reserve go in lowering interest rates to save the country from a long and painful recession?

Ratcheting its key rate from the current 1 percent all the way down to zero can't be ruled out. But there are risks in taking such an unprecedented step: namely, that it wouldn't work in turning around the economy and breaking through a stubborn credit clog.

Eventually, a zero percent rate - virtually "free" money - could trigger a speculative investment frenzy that could feed a bubble that pops, wreaking havoc on the economy. And that, in turn, could lead to the very kind of financial crisis now afflicting the global economy. Former Fed Chairman Alan Greenspan - now partly blamed for the current problems - has called today's crisis a "once-in-a-century credit tsunami."

Emphatic as it was, the bold rate reduction the Fed ordered Wednesday and the possibility of even lower rates ahead are no panacea. Even lower rates won't necessarily entice skittish Americans to spend and squeezed banks to lend more freely - forces at the heart of the economic woes.

With any luck, though, the Fed's action will cushion the blow to the country, which is on the brink of - or already in - its first recession since 2001.

The Fed slashed its key rate by half a percentage point to 1 percent, a rate not seen since 2003 and part of 2004. The rate hasn't been lower since 1958.

In a gloomier assessment of the economy, Fed policymakers said "the pace of economic activity appears to have slowed markedly" as consumers and businesses cut back on spending, and economic slowdowns in other countries sap demand for U.S. exports, which have helped keep the economy afloat.

Moreover, the "intensification of financial market turmoil" is likely to weigh on consumers and businesses, further reducing their ability to borrow money, the Fed said.

Underscoring the Fed's sense of urgency is this fact: It took just 13 months for Fed Chairman Ben Bernanke, a student of the Great Depression, to ratchet down rates to the 1 percent mark. It took his predecessor, Greenspan, 2 1/2 years.

Many economists predict Fed policymakers will drop the rate again to half a percentage point, which would mark an all-time low, on or before Dec. 16 - its last scheduled meeting of the year. The Fed left the door wide open to more rate cuts, pledging to "act as needed" to revive the economy.

"We are in a crisis situation and everything is on the table," said Richard Yamarone, an economist at Argus Research. "If conditions deteriorate considerably, the Fed could go down to zero. It is absolutely a possibility, but I don't believe it is likely."

Yet even if the Fed were to lower its key rate to zero, that might not reverse the bunker mentality of consumers and lead them to ramp up spending.

More than in recent recessions, consumers have retrenched as vanishing jobs, shrinking paychecks and nest eggs, and sinking home values have made them feel less wealthy and less inclined to spend. Consumer spending - the single biggest chunk of overall economic activity - probably fell in the July-to-September quarter. That would mark the first quarterly drop since late 1991, when the country was emerging from a recession.

And just because borrowing costs are cheaper doesn't mean banks will feel more inclined to beef up lending to people and businesses.

"The problem is not the interest rate," said Sean Snaith, an economics professor at the University of Central Florida. "It is that no one is willing to loan, regardless of what the rate is. Lower rates will not make the problem go away. The credit crunch will take time to resolve. This is another action to just chip away at the gridlock in this economy, but we shouldn't expect a miraculous turn of events from this."

The Fed's move Wednesday meant the prime lending rate for home equity loans, certain credit cards and other consumer loans dropped to 4 percent. Even if the Fed were to cut its main rate to zero, the prime rate would fall to 3 percent but no lower.

The Fed's previous rate reductions, in fact, were blunted by the credit crunch. The Fed slashed rates by a whopping 3.25 percentage points between September 2007 and April 2008, one of the most aggressive campaigns in decades. Just a few weeks ago, the Fed lowered rates again in a coordinated action with other central banks around the world.

The Fed probably would want to stop short of zero, so it saves precious ammunition - meaning additional rate cuts - should the economy take a turn for the worse later on, some economists said.

Others believe the Fed would want to avoid the fate of Japan, which failed to revive its economy even after its central bank slashed rates to zero in 1999 and kept them there for six years before bumping them up again. Japan became mired in a decade of lost growth in the 1990s after real-estate prices collapsed. That caused a severe bout of deflation, which is a destabilizing drop in prices.

"Cutting rates to zero is a fairly desperate measure, and a lot of stigma is attached to it," Snaith said. "It would bring on comparisons to Japan."

There's also the worry that dropping rates to all-time lows would feed the type of speculative boom and painful bust that the country is now suffering through. Greenspan lowered rates to 1 percent in summer 2003 as he sought to aid the economy's slow recovery from the 2001 recession and fend off a remote - but dangerous - risk of deflation. He kept rates at that historically low level for a year.

Critics contend that those low rate fed the housing bubble and lax lending standards that eventually burst and imperiled the economy. The meltdown drove up foreclosures and forced financial companies to rack up huge losses on soured mortgage investments, laying low storied Wall Street firms and causing banks to fail.

Instead of dropping rates to zero, the Fed probably will turn to other weapons to battle the crisis.

The Fed has already created first-of-its-kind programs, such as getting cash directly to companies by buying up mounds of "commercial paper," the short-term debt firms use to pay everyday expenses such as payroll and supplies. That program, which started Monday, is helping to relieve credit stresses, economists said. The Fed also is providing loans to banks, has moved to provide a financial backstop to the mutual fund industry and has injected billions of dollars in financial markets here and abroad.

The Fed could opt to expand programs by enlarging loans it's now making, providing loans to other types of companies, or buying more and different types of debt. The Fed's balance sheet has doubled to $1.8 trillion in recent months, reflecting those other activities to get credit flowing again.

Because the Fed has wide latitude in these areas, many economists believe Fed policymakers are more likely to continue this route than to lower its key rate to zero.

No matter the relief tactics, though, the economy is due for more pain. The unemployment rate, now 6.1 percent, could hit 8 percent or higher by next year. Home prices are likely to keep sinking for some time, and nest eggs will continue to be battered.

"We've been in pain, and it will get more much severe over the next six months," predicted Mark Zandi, chief economist at Moody's (nyse: MCO - news - people ) Economy.com. "The economic damage of the financial panic has already been done, and the Fed is trying to limit the damage as best it can."

EDITOR'S NOTE: AP Economics Writer Jeannine Aversa has covered the Federal Reserve and the economy since 1999.

Source: http://www.forbes.com/feeds/ap/2008/10/29/ap5622726.html