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Fed Employs Bold Rate Cut to Boost Economic Growth

December 16, 2008 at 6:05 PM EDT
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The Fed slashed the target for a key interest rate to a record low of zero percent to a quarter point on Tuesday. Financial analysts examine the possible impact of the Fed's move.

JEFFREY BROWN: The Federal Reserve continued its move into uncharted territory today with another big rate cut, a vow to use all of its various powers to restart the economy, and a forecast that exceptionally low interest rates will remain for some time.

We discuss all of that now with Laurence Meyer, a former member of the Federal Reserve Board of Governors. He’s now vice chairman of Macroeconomic Advisers, an economic consulting and forecasting firm.

And William Ford, former president of the Federal Reserve Bank of Atlanta, now professor of finance and monetary policy at Middle Tennessee State University.

Well, Larry Meyer, the Fed went even further than expected today. How do you interpret the move?

LAURENCE MEYER, former governor, Federal Reserve: Well, they pulled out all stops today. They did everything we would have expected them to do relatively soon at once and immediately. And it reflects how bad the state of the economy is.

Even if they go to the extreme with their policy instruments here, they won’t get very favorable outcome, but they have to do the best they can, so they lowered the funds rate from 1 percent to a range of zero to 25 basis points, more aggressive than the markets expected.

They indicated that the rate would be kept exceptionally low for some period, again unexpected, using what we call commitment language, about how they’re going to have the rate in the future. And then, finally…

JEFFREY BROWN: Because they didn’t have to say that, right?

LAURENCE MEYER: They didn’t have to say that. I mean, they’re trying to convey to the markets that they’re prepared to keep rates very low for some period of time.

And then, third, they indicated that they are not out of business. They still have other instruments that they can use, particularly targeted purchases of longer-term government securities and private assets.

Fed exhausting all options

William Ford
Former Atlanta Federal Reserve president
[The Fed is] attempting to address that by saying that we are getting into the secondary market for mortgages to help encourage primary lenders to make mortgages so that we could ... restore some sense of stability into the housing markets.

JEFFREY BROWN: Now, William Ford, what's the hope here? I mean, if -- in terms of the real impact on the economy -- if cuts have not worked so far, cutting it this low, what are they hoping to do and how quickly?

WILLIAM FORD, former president, Federal Reserve Bank of Atlanta: Well, they're obviously hoping to, first of all, get at the fundamental problem that triggered all of this, which is the housing crisis, which we're still seeing come down on us.

And they're attempting to address that by saying that we are getting into the secondary market for mortgages to help encourage primary lenders to make mortgages so that we could get the glut of houses moving off the market and restore some sense of stability into the housing markets.

Also, by lowering the Fed funds rate to near 0 percent or 0 percent, that also lowers the prime rate of interest by the same amount, essentially 1 percent, so it's at -- before the prime rate was at 4 percent, 1 percent plus 3 percent -- now it's going to be down around 3 percent, which effects many, most, in fact, of the people who have credit cards. They find the rate of interest that they have to pay is keyed to the prime rate of interest.

So it will eventually also help credit card borrowers. So they're helping mortgages borrowers, credit card borrowers, and they're also entering broad sectors of the market by helping the insurance company AIG, by attempting to help the money market funds, which are now going to be having some real stress, since they are investments in short-term securities will be yielding very little.

So they really are, as Larry Meyer said, moving broadly, moving aggressively, using every tool in their old kit and throwing in some new ones to try to step up the economy's recovery.

Examining long-term securities

Laurence Meyer
Former Federal Reserve official
So short-term security rates are already very low. If (the Fed) can buy longer-term Treasury securities, they can lower the rates there relative to short rates.

JEFFREY BROWN: Well, Larry Meyer, when they use that term, "employ all available tools," they mean -- they're signaling these things beyond interest rates, right? Because how -- can they go any lower with interest rates?

LAURENCE MEYER: Well, they can go firmly to 0 percent, but this is basically to 0 percent. No, they're indicating that, despite the fact of being near 0 percent, there are other things that they can do. Those are the targeted purchases. They can try to lower long-term rates now relative to short-term rates.

JEFFREY BROWN: Explain that, because there's a phrase in there that I think is getting some attention in the statement. It says, "The Fed is also evaluating the potential benefits of purchasing longer-term Treasury securities."

LAURENCE MEYER: So short-term security rates are already very low. If they can buy longer-term Treasury securities, they can lower the rates there relative to short rates. And it's long rates that are much more important in stimulating aggregate demand than short-term rates.

JEFFREY BROWN: Demand in things like mortgages?

LAURENCE MEYER: Mortgages and corporate loans and the like.

JEFFREY BROWN: Is that how you would interpret that, William Ford, in terms of these other available tools?

WILLIAM FORD: Larry is exactly right. They're attempting in economist talk to lower the entire Treasury yield curve, not just short-term interest rates, but also long-term rates, because the -- for instance, the mortgage rate that homeowners pay is keyed closely to the 10-year Treasury note.

And so if they lower that rate by buying Treasury notes and bonds, which bids up the price and lowers the yield, that should help -- they hope it will help make mortgage rates lower.

And, as Larry mentioned, it may also help -- they hope it will help to lower corporate borrowing rates, which are also keyed to the longer end of the Treasury yield curve, when they're going out for long-term bonds and things of that nature.

JEFFREY BROWN: Well, many people, Larry Meyer, have talked about the example of Japan in lowering rates to 0 percent or near 0 percent for a long time. What lessons do we learn from that that can apply to now?

LAURENCE MEYER: Well, I think the first lesson is that, if Japan made a policy mistake -- and they probably did -- it was that they didn't get to 0 percent fast enough.

So all the research that the Fed says, that when you have a very weak economy, where you're perhaps worried about deflation, when you face the zero nominal bound, you should be extremely aggressive. If you think that rates are going to go below 1 percent, take them immediately to 0 percent, OK? So that's the lesson from Japan. Also...

JEFFREY BROWN: And do you see the Fed acting that way now?

LAURENCE MEYER: Oh, absolutely, yes. And, also, that you need complementary fiscal policy, and you need that rapidly, as well. Speed matters.

JEFFREY BROWN: And that's what we're talking about with the stimulus plan. You heard President-elect Obama again today.


Potential trouble down the road

William Ford
Former Atlanta Federal Reserve president
And the question then becomes, in the minds of many economists, are we setting ourselves up for trouble later with all the liquidity that's going in the market?

JEFFREY BROWN: Now, William Ford, you mentioned at the top here in your first answer about all of the things that the Fed is taking on. What's the potential downside of all of that exposure? There is one, right?

WILLIAM FORD: There is some risk further down the road that a lot of economists are concerned about. For example, you may recall that you were reporting just a few months ago in the review of Alan Greenspan's 18 years of tenure that he was taking some criticism about having kept the federal funds rate at 1 percent for too long a period and that that indirectly triggered problems later.

Now, here we have the Fed taking it below what Alan Greenspan was criticized for, telling us, as Larry correctly pointed out, that they're going to keep it there for quite a while. And the question then becomes, in the minds of many economists, are we setting ourselves up for trouble later with all the liquidity that's going in the market?

The Fed, of course, would reply, I think -- Larry may want to comment on this -- that, if and when we get the turnaround we're all hoping for, and if inflation starts to rear its ugly head, the Fed will then quickly respond by taking rates up.

But there are a lot of people who think the Fed is moving too broadly into too many areas of the economy and that we may later see some unfavorable feedback from that. That is the other side of the picture.

JEFFREY BROWN: Yes. Well, we just have 20 or 30 seconds here. But you think they just have to do all this right now, right?

LAURENCE MEYER: Inflation isn't the problem. Deflation is more likely than high inflation. So, you know, they will ultimately face a problem of exit, OK, and the timing and...

JEFFREY BROWN: A problem of exit? But that's one we're not even...

LAURENCE MEYER: A couple of years from now, we can talk about it.

JEFFREY BROWN: A couple of years from now?

LAURENCE MEYER: A couple of years from now.

JEFFREY BROWN: And that's that phrase you said, for a long, bad haul, that...


JEFFREY BROWN: ... I mean, that for some time...

LAURENCE MEYER: That's a pretty long period.

JEFFREY BROWN: Yes. All right, Laurence Meyer and William Ford, thank you both very much.

WILLIAM FORD: You're welcome.