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The Fed Is Getting Desperate

by @ 3:15 pm on December 16, 2008. Filed under Credit Crisis, Economics

We’re about to enter an era of near-zero interest rates:

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 cut its target for the overnight federal funds rate to a range of 0 to 0.25 percent, a record low, virtually bringing the United States to the zero-rate policies that Japan used for six years in its own fight against deflation. The rate had previously been 1 percent, and a cut of a half-point had been widely expected.

The move, which affects the rate at which banks lend their reserves to one another, was to a large degree symbolic. Demand for interbank loans has been so low that the actual Fed funds rate has been far below the previous target for a month and hovered at barely 0.1 percent in the last several days.

In its statement announcing the cut, the Fed’s Open Market Committee made it clear that it still had ammunition with which to stimulate the economy and referred the wide array of new lending programs that essentially allow it to pump money directly into financial institutions.

“The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” it said. Among those tools, it cited the continuing purchase of agency debt and mortgage-backed securities and the “potential benefits of purchasing longer-term Treasury securities.”

And the Fed’s pump-priming activity isn’t just limited to setting historically low interest rates:

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.

As Brad Warbiany notes, the most remarkable thing about all the liquidity that the Federal Reserve has been pumping into the economy over the past two months, especially when it’s combined with the hundred of billions of dollars that have been spent by the Treasury Department in it’s own efforts, is how little impact it seems to be having on the economy. The stock market is still down, housing prices are still going down, and unemployment is continuing to climb.

I’ve got to wonder what the Fed thinks it can do next if this latest idea doesn’t work, and it makes me think that by lowering interest rates to a level that nearly amount to paying people to borrow money, the Federal Reserve members see numbers that are making them very nervous and they don’t necessarily know what to do about it.

Of course, even if it does work, there’s a potential problem down the road:

“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.”

In other words, out of the frying pan, and into the fire.

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