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  Date / Time: 12/17/2008 3:29 AM UTC

  Fed Cuts Key Rate to Record Low
  

  The Federal Reserve yesterday exhausted its most fundamental tool for managing the economy, slashing short-term interest rates to nearly nothing and promising aggressive new tactics to arrest a deepening recession.

  The central bank cut its target for the federal funds rate, at which banks lend to each other, from 1 percent to a target range of 0 percent to 0.25 percent, the lowest rate on record. Although the Fed has no more room to reduce the interest rate -- it has been cut 10 times in 15 months -- the bank's leaders said in a statement that they would use "all available tools" to bolster the economy.

  Fed policymakers, noting that financial markets remain strained and economic activity weak, strongly suggested it would use unconventional means to lower the rates Americans pay for mortgages, car loans and business loans.

  "The Fed is now focused on getting credit to businesses and consumers rather than just pumping money into the economy in a passive way," said Julia Coronado, senior U.S. economist at Barclays Capital.

  The announcement jolted Wall Street, driving the Dow Jones industrial average up 4.2 percent, or 360 points, and sending long-term interest rates on government bonds and mortgage securities plummeting in anticipation of future Fed interventions.

  Normally, the Fed stimulates growth simply by lowering short-term interest rates, thus injecting money into the economy. That tactic is not working the way it normally would; lending rates have risen sharply due to the financial crisis. With yesterday's move, the Fed was acknowledging that it has done all it can with ordinary rate cuts, and said it is likely to leave that rate at "exceptionally low" levels for "some time."

  In the past, people wanting to understand the central bank's policies would look to those decisions on the federal funds rate and accompanying statement. With the benchmark rate now basically stuck in place for the foreseeable future, Fed watchers will instead want to pay attention to which lending programs the Fed creates or expands to understand how it is guiding the economy, a senior Fed official told reporters yesterday in a conference call.

  In its statement, the Fed said it "stands ready" to expand purchases of mortgage-related securities; it already plans to buy $600 billion of them under a program announced last month that has driven mortgage rates down by half a percentage point. Expanded purchases would likely drive mortgage rates lower.

  Similarly, the Fed said it is "evaluating the potential benefits" of purchasing long-term Treasury bonds, the prospect of which drove the rates on 10-year Treasurys down by 0.2 percentage points in trading yesterday.

  Finally, the statement noted a Fed program being created to funnel money toward credit card loans, auto loans, student loans and small-business loans. It said the Fed "will continue to consider ways of using its balance sheet to further support credit markets and economic activity," which could include such steps as creating a similar program to buy commercial real estate loans or mortgage debt not backed by government-sponsored companies Fannie Mae and Freddie Mac.

  The rate cut and statement were approved unanimously by the Fed's policymaking committee, indicating that a broad set of Fed leaders were on board with the strategy-- including presidents of regional Federal Reserve banks, many of whom were hostile to aggressive rate cuts and unconventional intervention in the economy earlier in the year, partly out of fears over inflation.

  Apparently the rapid drop in prices has helped assuage those fears; the Labor Department said yesterday that the consumer price index fell 1.7 percent in November, its steepest drop on record.

  The depth of the economy's contraction seems to have persuaded even reluctant Fed leaders to sign on.

  "The situation is so dire that everyone was of the same opinion that we need to put out the big fire first and then worry about the rest," said Sung Won Sohn, an economist at California State University at Channel Islands. "The risks here are not just of a minor contraction, but possibly a repetition of the lost decade of Japan in the '90s or even the Great Depression. The consequences are so catastrophic nobody wants to take that chance."

  The Fed declined to explicitly cut its target to zero percent for technical reasons, the senior Fed official said. The central bank sets a target for the federal funds rate, then buys and sells short-term Treasury debt to try to maintain that rate among banks, pumping money into the economy and sopping it up as necessary.

  Normally, the actual federal funds rate is very close to that target level, but lately, the vast size of the Fed's balance sheet has created technical difficulties that mean the actual funds rate has frequently veered far from its intended level, a reality that the Fed is acknowledging by setting a range rather than a single numerical target.

  "They're at such a low level that it's gotten really hard to control the funds rate," said John Silvia, chief economist at Wachovia. "This cut is essentially saying 'Let's get this over with.' "

  Analysts expect the actual federal funds rate to be 0.10 to 0.15 percent. The change may not lower borrowing costs for ordinary Americans by much immediately, but that could change when the financial crisis eases, and in the meantime it could help banks rebuild their battered capital structures, as they can borrow money essentially for free and the lend it out for much higher rates.

  The very low rate could create problems for some money-market mutual funds, however, especially those that invest heavily in government debt. The managers of these funds generally deduct their fees from the interest that the funds earn, and with interest rates extraordinarily low, those earnings may be too low to cover management fees.

  That, said Silvia, could lead some money-market mutual fund managers to invest in longer-term investments or riskier assets. Others have suggested that they need to revamp their fee structures

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