The Federal Reserve ripped up decades of monetary policy-making, saying it would no longer set an explicit target for US interest rates and instead set a range – and it said it would be happy to see rates at zero.
In its groundbreaking statement, it said it would employ a whole new set of tools to bring down interest rates for struggling borrowers, extending its interventions across the money markets and in effect printing money to halt the economy's downward spiral.
Markets had expected the Fed to cut rates from their already historically low level of 1 per cent, but instead of stopping at 0.5 per cent, as most forecasters had predicted, it said it would target a federal funds rate in a range of zero to 0.25 per cent.
And in a comment that sent the Dow Jones up 4.2 per cent by the end of the day, the Fed's open market committee (FOMC) added that it expected to keep rates "exceptionally low" for some considerable time. In explanation, it painted a grim picture of the economic outlook.
"Since the committee's last meeting, labour market conditions have deteriorated, and the available data indicate that consumer spending, business investment and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further."
There was also an expansive description of the other measures that the Fed has already taken and can take in the future to affect real-world interest rates, including spending and lending new money in the financial markets. This process, known as quantitative easing, was foreshadowed in a speech by Ben Bernanke, the Fed chairman, earlier this month.
"The focus of the committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level," the FOMC said yesterday.
Economists have been concerned about the Fed running out of ammunition to tackle the credit crisis, given that official interest rates have been tending towards zero with little sign of an easing of credit conditions further down the chain, stifling business investment and consumer activity.
Doug Roberts, chief investment strategist at Channel Capital Research in New Jersey said: "The message is they're instituting quantitative easing on a fairly large scale. That's what the stock market wanted to hear, that the Fed didn't run out of bullets."
The federal funds rate is the over-night interest rate charged by the biggest banks to their peers, the first step in a chain of lending that eventually affects borrowing costs across the markets. The setting of a target for the Fed funds rate has appeared an increasingly academic exercise in recent months, since the rate has been allowed to slip far below that target. Since it was cut to 1 per cent in October, the effective rate has averaged 0.33 per cent.
Financial markets had long ago priced in more cuts in interest rates, which have been reflected across a range of government securities. In the hours after the announcement, these yields fell to new record lows. The yield on the 30-year Treasury hit a new low of 2.82 per cent. For the second time in two weeks, the Treasury sold new one-month debt at a zero interest rate.
Earlier in the day, government data showed inflation plummeting as the US economy's recession deepens. The consumer price index fell 1.7 per cent in November, on top of a 1 per cent drop in October, back-to-back records since the Labour department began compiling data in 1947. The slump in the price of oil and other commodities led to the deflation. Stripping out food and energy, prices were flat.
Meanwhile, the Commerce Department said the construction of new houses dropped 18.9 per cent to an annual rate of 625,000 units from 771,000 units in October, the lowest since the department started collecting monthly starts data in 1959, and well below the 740,000-unit pace that Wall Street analysts had expected.
The US has been in recession since December of last year, the National Bureau of Economic Research has ruled.
A new weapon: Licence to print money
With official United States interest rates now set at close to zero, the Federal Reserve must find alternative weapons in its fight against deflation and the slump in the economy, and the central bank's interest rate-setting committee was at pains yesterday to show there is much still in the armoury. The measures are known as "quantitative easing" because they boost the money supply, as the Fed prints money to pay for the programmes and reflate the economy.
Over the next few months, it will purchase some $600bn of "agency debt", that is debt and mortgage-backed secur-ities connected to the nationalised mortgage finance agencies, Fannie Mae and Freddie Mac. The previously announced programme is aimed at bringing down mortgage rates in order to stimulate the housing market.
The Fed is also evaluating the benefits of purchasing longer-term Treasury securities, which act as benchmarks for interest rates through the financial system, adding extra demand which will push their rates lower and encourage lenders to seek borrowers in the private sector. The Fed pointed, too, to its Term Asset-Backed Securities Loan Facility, providing lending to the secondary market for credit card and consumer and business debt, which it announced last month and is aimed at ending the drought of new lending to the real economy.Reuse content