WASHINGTON — With a half-point cut to its benchmark lending rate Wednesday and a signal of possibly further reductions, the Federal Reserve again finds itself approaching new territory.
The rate-setting Federal Open Market Committee knocked down the federal-funds rate — the amount charged for overnight lending between banks — to 1 percent. In a tandem move, commercial banks lowered the prime rate by a half point to 4 percent.
The prime rate is what they charge their best customers.
The Fed also signaled a willingness to go further, even though it's never lowered its benchmark target rate below 1 percent, a level that almost would be tantamount to giving money away. Such a move could spark the economy, but also could invite bad lending because there's little cost to spending cheap money.
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The last time the fed funds rate was this low was a period from June 2003 to June 2004, and the low cost of borrowing money then created the housing bubble that led to today's collapse in housing prices.
Before that, the last time the rate stood so low was in 1958, during the second term of Dwight D. Eisenhower.
In both instances, rates didn't go lower. But Wall Street is now rooting for even further cuts to the benchmark rate, lowering the cost borrowing of businesses and consumers alike.
"I think the last time the FOMC was in this neighborhood (in 2003), they did view 1 percent as the floor," said Vincent Reinhart, a former chief economist of the rate-setting committee and now a researcher at the American Enterprise Institute, a conservative policy organization.
During the time when rates were frozen at 1 percent, the Fed expressed concern that still lower rates would be disruptive to financial markets.
But Wednesday, there was no expression of practical limits for how low the Fed could go. And gone was previous Fed language citing risks weighted to the downside. Wednesday's FOMC statement explicitly said that "downside risks to growth remain." It might sound like hair splitting, but it's how the Fed signals its view of future economic conditions.
"The absence of any indication from the FOMC that limits to its easing moves are emerging also indicates a rather aggressive Fed," said Peter Kretzmer, an economist with Bank of America, in a note to investors.
The credit crunch that is hampering lending between banks and to consumers is likely to mute much of the impact of rate cuts, he said, and the Fed is likely to continue with aggressive steps like providing short-term lending directly to U.S. corporations to address the ongoing financial turmoil.
Late Wednesday, the Fed announced it would enter a special arrangement to ensure access to dollars in four important developing nations — Mexico, Brazil, Singapore and South Korea. The reciprocal currency swaps with the central banks of these nations builds on what's already been done with developed nations, and is designed to boost emerging economies that are important enough to threaten the stability of the broader global financial system.
Meanwhile, while markets read in the Fed's statement the prospect of further rate cuts, Reinhart saw caveats suggesting a pause at 1 percent for the next several months.
"I think what they signaled is there is a bit of a speed bump at 1 percent," said Reinhart, who left the rate-setting FOMC in 2007. "I think they've showed a willingness to ease . . . they are saying this is a good time to pause and see if the whole set of policy actions (to ease a global credit crunch) get traction."
Wednesday's deep cut in lending rates was expected, in part because many economic indicators now point to a U.S. economy in recession. Confirmation could come as early as Thursday, when the Commerce Department releases what are sure to be dismal third-quarter economic growth numbers that are expected to show a contraction.
The Fed statement avoided the "r" word, but hinted at recession.
"The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports," the Fed said. "Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit."
Citing the decline in consumer spending, the Fed highlighted the all-important consumer, who drives more than two thirds of all U.S. economic activity. Consumer confidence is now at all-time lows, according to Tuesday's release of the Conference Board's consumer confidence index. Consumer sentiment fell to its lowest point ever since the index came into use in 1967.
Flagging consumer confidence, the expected contraction in economic growth and nine consecutive months of job losses all point to a recession. In a research note Wednesday, Brian Bethune, U.S. economist for forecaster Global Insight, believed the Fed has made clear it now views the inflation threat from earlier this year as no longer a problem.
"That being said, we are projecting that the Fed will lower interest rates by (another half point) in the next several months, to historically low levels for federal funds, as the recessionary conditions in the economy will be become even more apparent in reports on the economy in the fourth quarter of 2008," he wrote.
By December, there will be a clearer sense of the way forward. Doubt surrounding who wins the presidency will be resolved and there will be clarity on whether Congress will push a second stimulus plan, which already has been blessed by Fed Chairman Ben Bernanke.
And from that point forward, much is likely to be seen through the prism of the battered consumer.
"Essentially, it's what the consumer does that determines how deep and long this recession is," Reinhart said.
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