Uncharted Territory For The Fed
The Federal Reserve announced today that it was setting the target for it’s overnight federal funds rate to between 0% and .25%. With commodities and consumer prices falling in the face of contracting economies world wide, there is a real risk of deflation, which allows the Fed to lower interest rates to practically zero.
Since the Committee’s last meeting, labor 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.
Meanwhile, inflationary pressures have diminished appreciably. 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 further in coming quarters.
Today’s move is unprecedented, the only other time the Fed considered taking interest rates this low was back in 2000 where transcripts from FOMC meetings that year showed that while there was some support, ultimately it was decided not to lower rates that far. By taking rates to zero the Fed is pretty much signaling that it’s all in and will be using it’s balance sheet from now on to affect monetary policy.
Many expect the Fed to become a major player in the mortgage securities market in an attempt to bring down home lending rates. At this point it is doubtful that any meaningful recovery can begin until the housing market rebounds.
The Fed has already added significant risk to it’s portfolio and seems ready to take on more. The question is how much more will the Fed’s balance sheet grow, which has already nearly tripled in the past year.
It will take time for capital markets to return to some sort of normalcy and quite a few institutions will face more writedowns in the near future as home prices keep falling. We may see many of them continue to build up capital reserves, so who knows how much more liquidity the Fed will have to pump in to get them lending again.
