USA economy: Ground zero
December 16, 2008 – The Economist Intelligence Unit
The Federal Reserve veered into uncharted Today’s move, while hugely important
territory Tuesday, slashing its main interest symbolically and as a statement of Fed
rate to nearly zero as it struggles to rescue the determination, will have little direct effect in
economy from the worst recession in a the lending markets.
generation and prevent the onset of deflation.
The Fed’s move, the most dramatic yet in a
year of violent shocks for the US economy, is That will be less true as the Fed pursues
unlikely to spur lending in the short term, but increasingly unorthodox measures to stimulate
it shows the central bank’s determination to lending and economic growth. In the statement
pursue increasingly aggressive steps to fight following Tuesday’s meeting of the Federal
the recession. Open Market Committee, the Fed said it “will
employ all available tools to promote the
By cutting its benchmark lending rate to a resumption of sustainable economic growth.”
range of 0 to 0.25%, the Fed essentially This could eventually include purchasing
abandoned its traditional policy of using longer-term Treasury securities on the open-
interest rates to manage the economy. Instead, market in vast quantities. That would be a big
the Fed will buy “large quantities” of bonds departure for the Fed, which normally controls
and other securities, essentially printing vast only its short term federal funds rate, relying
amounts of money in the hope that banks will on changes there to filter through to the long-
lend it to consumers and businesses. Banks, term bond market, which determines
badly weakened by plunging asset values and consumer borrowing costs. Buying longer-
a surge in bad loans, have been hoarding cash term bonds would likely have a more direct
to protect their balance sheets, starving the effect on lowering the cost of borrowing.
wider economy of capital. Although banks
now have access to money that is nearly free, The Fed has also announced several other
it does not guarantee they will increase steps that would have been unthinkable a few
lending. The Bank of Japan’s policy of zero months ago, such as providing liquidity not
interest rates from 2001 to 2006 did little to just to financial institutions—its traditional
revitalise the economy in the early years. role—but directly to highly stressed borrowers
or investors in key credit markets. Hence, the
Although the Fed has only now cut its target Fed is providing support to the commercial
interest rate to nearly zero, conditions in the paper market, where corporations finance
overnight lending market have been at that short-term business operations. It will also
level for a while. In more normal times, the soon purchase up to US$100bn in debt issued
Fed can adjust liquidity in the federal funds by the mortgage giants, Fannie Mae and
market—where commercial banks borrow Freddie Mac, and up to US$500bn in their
from the central bank—so that the actual, or mortgage-backed securities—all in an effort to
effective, federal funds rate matches the target bring down home lending rates. The central
rate, which until today had been 1%. But the bank will also lend against asset-backed
market has been awash with funds for some securities collateralised by auto loans, student
time, and the effective federal funds rate has loans and other forms of commercial debt,
been below the target rate since October 10th. with an eye on improving liquidity and
Indeed, the actual overnight borrowing rate spurring lending in those markets as well.
has been below 0.25% for most of December.
Central banks are meant to be “lenders of last employment falls, equity markets search for a
resort”, and the Fed has embraced that role to bottom and other asset prices continue to fade.
an unprecedented degree. In effect, the Fed is These dire conditions will depress demand and
creating money and trying to push it through keep prices under control, providing room for
the blocked arteries in the financial system. the Fed to continue stimulating the economy.
This is reflected in the Fed’s balance sheet, Indeed, the government announced Tuesday
which stood at $2.29trn on December 11th, up that headline consumer prices in November
sharply from US$888bn just three months fell 1.7% month on month. Although this was
before. As the Fed expands its plans to buy up due mainly to the plunging cost of energy,
other mortgage and consumer debt, it will soar core prices, which exclude food and fuel, were
further. Eventually, the Fed may even consider stagnant from the month before, a sign that
purchasing lower-rated securities, or those price pressures are fading as the economy
with less-than-strong collateral, steps it would suffers. A greater fear, which may lie ahead, is
not have considered in the past. The Treasury the onset of deflation, or a general fall in the
would have to accept some of the credit risk to price level. There is no real evidence of this
make such moves legal for the Fed. yet, but if demand continues to weaken, the
Relief is not imminent Fed may face still another threat.
Despite these aggressive measures, banks are When Japan suffered from debt, deflation and
unlikely to resume lending to any significant plunging demand in the 1990s, the Bank of
degree in the coming months. Conditions in Japan was slow to react. The Fed, by
the real economy remain desperate: employers comparison, has acted early and aggressively
cut 533,000 jobs in November, and every to try to cushion the effects of a punctured
major gauge of output—consumer spending, asset bubble and a fractured financial system.
industrial production, factory orders—is Ben Bernanke, the chairman of the Federal
falling. One in ten home mortgages is either in Reserve, has made it clear that he will take
foreclosure or delinquent. All of this has extraordinary measures to keep the financial
placed pressure on banks as mortgage losses system functioning. His moves to date have
accelerate and bad debts from other sectors of clearly helped, but they have not come close to
the economy begin to materialise. Under these restoring lending markets to anything
circumstances, banks will be reluctant to lend. approaching normalcy. That day is still some
Just as important, demand for credit from way off.
consumers and businesses will be muted as