WASHINGTON — The Federal Reserve on Wednesday slashed interest rates to four-year lows, capping a dramatic policy turn in October as the U.S. confronts a severe financial crisis and almost-certain recession.
Fed officials even left the door open to additional rate cuts to levels not seen in a half-century, putting rates on a once-unthinkable path towards zero.
The Federal Open Market Committee voted unanimously to lower the target federal funds rate at which banks lend to each other by 0.5 percentage point to 1%, its lowest since between June 2003 and June 2004. That outcome was universally expected by Wall Street economists in a Dow Jones Newswires survey.
The Fed also reduced the discount rate charged for direct loans to banks by 0.5 percentage point to 1.25%, responding to requests from Fed district banks in Boston, New York, Cleveland and San Francisco.
"The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures," the FOMC said, while the financial crisis "is likely to exert additional restraint on spending."
Though the fed funds rate was 1% as recently as 2004, few if any on Wall Street thought officials would revisit those levels again.
After all, the 2001 to 2003 easing campaign was seen by some, in hindsight, as an overreaction to the mild 2001 recession and over-hyped deflation fears. Those cuts and the slow pace of tightening thereafter were criticized as the root cause of the ensuing U.S. housing bubble, the collapse of which is at the heart of the current economic storm.
But this time is different. Far from a mild downturn, the U.S. economy is poised to contract sharply. Economists expect third quarter gross domestic product figures, due for release Thursday, to show a 0.5% contraction, at an annual rate. The forecasting firm Macroeconomic Advisers expects an accelerated decline of 2.8% in the current quarter followed by another GDP dip in early 2009.
"They can go below 1%," said Brian Bethune, economist at IHS Global Insight. "They can go to 0.5% and they can even go to zero if they have to," he added.
"We're in the eye of the storm so they've basically got to use all of the ammunition they have to turn the situation around," Bethune said.
Meanwhile, the unemployment rate is expected to climb well above 7% in coming months from its current level of 6.1%. And inflation rates, though still quite elevated on an annual basis, should come down quickly in response to falling oil and gasoline prices.
"In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability," the Fed said.
As recently as the FOMC's last scheduled meeting, on Sept. 16, officials had warned that inflation remained a "significant" concern. But as the credit crunch claimed more victims and showed signs of spilling over to consumer and business spending, Fed officials on Oct. 8 — in an unprecedented joint rate cut with other major central banks including the European Central Bank and Bank of England — lowered official rates by 0.5 percentage points.
Those actions including Wednesday's rate cut should promote a return to moderate economic growth, the Fed said, though "downside risks to growth remain."
Fed officials will monitor the economy and markets and "act as needed" to promote economic growth and price stability, the Fed said.
Also this month, the Fed announced a series of programs to help ailing short-term debt markets, particularly by easing corporations' access to loans they need to fund their daily operations. The market for those IOUs, or commercial paper, has suffered as money market funds — the largest group of investors in the market — remain spooked in wake of the collapse of Lehman Brothers. Some money funds had incurred significant losses from defaulted Lehman debt.
Under the Money Market Investment Funding Facility the Fed announced last week, the Fed will provide funding to help money market funds purchase certificates of deposits and commercial paper. And through its Commercial Paper Funding Facility, a complementary program that started Monday, companies such as American Express and General Electric can sell their three-month commercial paper to the Fed.
The Fed has also extended loans to banking organizations to purchase asset-backed commercial paper, started paying interest on banks' required and excess reserve balances and boosted the size of its Term Auction Facility auctions — all in effort to encourage lending.
There are preliminary signs the Fed's backstop programs are working. A key lending rate, the London interbank offered rate, for instance, was lower Wednesday, extending a streak of consecutive daily declines over the past two weeks.
"The real story regarding the Federal Reserve is its various liquidity operations; the federal funds rate is second fiddle," said Miller Tabak bond strategist Tony Crescenzi in a research note before the FOMC decision.
Still, the fed funds rate remains a powerful tool given the new global nature of rate cuts. Until recently, the U.S. was largely alone in easing rates given that the root cause of the global downturn has been the bursting of the U.S. housing bubble.
And even if the Fed is entering the final phase of its 13-month fed funds easing cycle, other central banks may just be starting. China's central bank lowered rates Wednesday for the third time in two months, following an unexpected rate reduction on Monday by the Bank of Korea. Norway's central bank also lowered rates Wednesday.
The ECB and BOE are expected to cut interest rates further when those central banks meet next month.