The Fed's Historic Actions May Not Have Historic Consequences
On December 16, the Federal Reserve made an unprecedented move to lower it target interest rate from 1.0 percent to a range of zero to 0.25 percent. The decision was more dramatic than expected and it sent long-term mortgage interest rates plummeting to the lowest averages on record.
The impetus for flat lining the federal funds rate, the rate banks charge each other for transfers, was the lack of liquidity in the markets as well as disappointing statistics from the general economy in the latest month.
"Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production has declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further," the Federal Open Market Committee, said in its statement. "...The Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."
In addition to causing a sharp decrease in mortgage interest rates, the Fed's historic move also resulted in a rallied stock market as the Dow Jones industrial average closed up 359.61 points or 4.2 percent.
Yet not all economic indicators point to confidence in the Fed's monetary policy. The day after the decision, foreign currency markets posted declines in the U.S. dollar against other notes.
Moreover, many analysts wonder if the Fed has crippled itself by effectively removing its power to influence the economy with lower interest rates. "The Fed's action will not have a real effect," said Timothy A. Canova, associate dean and professor of international economic law at Chapman University. "The most relevant page in economics is Keynes' description of a liquidity trap, when investors' expectations are for negative balance sheets."
Indeed, some say the most recent rate cut was mostly symbolic, as the Fed's branches had been lending to each other so little that the rate had been close to zero for weeks anyway.
Now that the Federal Reserve has eliminated its federal funds rate from play in the economic markets, it must now rely on other tools to stimulate lending and spending.
"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability," the FOMC promised.
Specifically, new measures will include purchasing "large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets," and expanding those purchases as necessary.
The question remains as to whether the bottomed-out interest rate and printing more money for more lending programs will stabilize the housing market and stop the current trend of deflation. The answer may lie in how quickly the Fed reacts to future market dives as well as how effective the fiscal policies and legislation are of president-elect Barack Obama and the Democrat-majority Congress. To this point, however, no action has yet inspired a turning point to restore investor confidence and it is certainly hard to predict what type of policy might have that effect.