Economic Comment
Our Weekly Economic Report
Every week our top economists discuss current economic reports and economic information that's covered in the news.
December 17, 2008
Fed Commits to Low Interest Rates
The Federal Reserve cut its short-term interest rate target to nearly zero percent on December 16. More important, the Fed announced "current economic conditions warrant exceptionally low levels of the federal funds rate for some time." In doing so the Fed is signaling that it will do whatever it takes to get the economy back on its feet. Investors responded positively to this news.During the past few months, many investors seemed to worry that the Fed was running out of ammunition to fight the financial crisis and the downturn in the economy. After all, you can't cut interest rates below zero percent. The Fed recognized these concerns. Therefore, it expanded its normally short statement after the interest rate cut to explain that it has more options than just cutting interest rates. Policymakers appear ready to pump more funds into the financial markets than a normal cut in interest rates would produce. Economists call this quantitative easing.
The Fed's goal is to increase market liquidity in order to thaw frozen credit markets. At this point, lenders are reluctant to make loans to other firms or individuals because they want to rebuild their own financial position. As a result, the Fed is trying to supply more funds than lenders want to hold for themselves. So far, this policy has helped restore lending in very short-term credit markets between major financial institutions. However, it has done little to help the housing market, which ultimately is the source of most lenders' problems.
Policymakers recognize they need to do more than just cut short-term interest rates and hope longer-term mortgage interest rates decline at the same time because this has not happened. Long-term mortgage rates remained stubbornly high during the past year even though the Fed has cut short-term interest rates by more than five percentage points. Consequently, the housing market has continued to deteriorate.
This week's Fed statement repeated an announcement made on November 25 explaining how the Fed intends to provide more funds for housing and hopefully lower mortgage interest rates. The Fed said it will purchase large quantities of mortgage-related debt and also stands ready to expand these purchases as conditions warrant. Mortgage interest rates have dropped more than a percentage point during the past several weeks because of the Fed's increased willingness to add funds directly into the mortgage market. These lower mortgage rates could boost home sales during the next few months. If so, investors may turn a little more positive on the economic outlook.
Japan faced similar problems with housing in the 1990s, and the Bank of Japan cut short-term interest rates to nearly zero percent. Japanese policymakers also followed an aggressive quantitative easing policy in order to provide abundant funds to financial institutions. However, the Japanese economy languished throughout the decade of the 1990s despite these very low interest rates. This possibility remains a major concern to many U.S. investors.
History suggests that the Japanese failed to do one very important thing: They did not require Japanese banks to write down the losses on their real estate loans, and many banks kept these bad loans on their books for years. As a result, they were reluctant to make new loans. U.S. policymakers appear to recognize this flaw in Japanese policies. Therefore, the U.S. government may still use some of its rescue funding to buy troubled assets from bank balance sheets or subsidize new loans to encourage more lending.
Prior to this week's Fed announcement, investors seemed to be unsure as to whether the Fed's policies would work. With this strong commitment from the Fed to keep interest rates low, more investors seem to be viewing the glass as half full rather than half empty. In other words, the Fed may have successfully convinced some investors that it will ultimately be successful in restoring healthy financial markets and positive economic growth. The big question for investors now: How long will it take for these policies to be effective and how bad will the economy get in the meantime?