Fed's rate cut acknowledges gravity of situation - and its failure to improve it

Now that the Fed has played its last available card on rates, it is looking to other means of stimulating the economy, writes Denis Stauntonin Washington

THE US Federal Reserve has portrayed its decision to slash interest rates to close to zero as evidence of the central bank's determination to use "all available tools" to prevent the recession gripping the US from turning into a slump.

The move is also an acknowledgement, however, of the gravity of the economic situation and the Fed's failure thus far to make much of an impact on it.

This week's rate cut was the 10th in 15 months, bringing the federal funds rate from 5.25 in September 2007 to a target range of zero to 0.25 per cent. The Fed stopped short of setting the rate at zero for technical reasons but its effect will be to allow banks to borrow money almost for nothing.

The cut is designed to make borrowing easier and to encourage US consumers to spend more.

But recent rate reductions have not been reflected in lower borrowing costs for consumers and businesses because banks remain slow to extend credit.

The consumer price index fell by 1.7 per cent in November, its steepest drop on record, and with unemployment edging towards 7 per cent, the US economy shows signs of a deep, protracted contraction.

Now that the Fed has played its last available card on interest rates, it is looking to other means of reducing the cost of borrowing, getting credit flowing and stimulating the economy.

The central bank is set to buy $500 billion (€348.6 billion) in mortgage-backed securities issued by homeloan agencies Fannie Mae and Freddie Mac and $100 billion in those companies' debts, effectively printing money to lower mortgage costs.

The Fed has also cut its rate for emergency borrowing by banks, helping to drive down the Libor interbank lending rate from a high of 4.5 per cent in October to less than 1 per cent this week.

It is already lending directly to companies through the commercial paper market and it is drawing up a plan to back credit card lending, car loans, student loans and small business loans.

The vast expansion of the Fed's balance sheet could help to ease credit but, as US president-elect Barack Obama acknowledged this week, it is unlikely to be enough to revive the US economy.

"We are running out of the traditional ammunition that's used in a recession, which is to lower interest rates," Obama said.

"It is critical that the other branches of government step up, and that's why the economic recovery plan is so essential."

Obama is planning a vast economic stimulus package that will create 2.5 million jobs over the next two years and involves repairing, replacing or creating roads and bridges and improving energy efficiency.

The problem with government infrastructure programmes is that they often take a long time to get started, requiring an exhaustive budgetary appropriations process and open tendering.

Obama's transition team is soliciting applications from state and local governments that have "shovel-ready" projects already approved and ready to go as soon as federal cash becomes available.

The new administration is expected to step up the programme initiated by Treasury secretary Hank Paulson under which the federal government has taken $250 billion in equity stakes in banks.

Obama's team wants to impose tougher requirements on banks that receive government help to lend to businesses and plans to help people who fall behind on mortgage payments to remain in their homes.

Democrats in Congress have pledged to push through a $600 billion economic recovery package in early January, including about $200 billion in tax cuts and $400 billion in spending on infrastructure projects, help for states, and other domestic spending intended to stimulate economic growth.