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How low can Fed go on interest rates?

Many economists predict another rate drop - to half a percentage point, an all-time low…

By Jeannine Aversa
ASSOCIATED PRESS

Austin American Statesman

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

Reducing 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 persistent credit clog.

Eventually, a zero percent rate — virtually “free” loans for banks — could trigger a speculative investment bubble that pops, wreaking havoc on the 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.”

The rate reduction that the Fed ordered Wednesday — emphatic as it was — and the possibility of even lower rates ahead aren’t guaranteed solutions. Even lower rates won’t necessarily entice skittish Americans to spend and squeezed banks to lend more freely — the forces at the heart of the economic woes.

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 the fact that it took just 13 months for Fed Chairman Ben Bernanke, a student of the Great Depression, to ratchet rates down to the 1 percent mark — something that took his predecessor Greenspan 2½ 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 boost 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.

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 used to peg rates on 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, from 5.25 percent to 2 percent, between September 2007 and April 2008, one of the most aggressive campaigns in decades. On Oct. 8, the Fed lowered rates again to 1.5 percent in a coordinated action with other central banks around the world.

The Fed probably would want to stop short of zero so it can keep some ammunition — meaning additional rate cuts \— in reserve if the economy takes a turn for the worse, some economists said.

Others think 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.”

No matter the relief tactics, though, the economy is in line for more discomfort. The unemployment rate, now 6.1 percent, could hit 8 percent or higher by next year. Home prices could keep sinking for some time, and nest eggs might 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 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.”

Article originally published at Statesman.com

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