Fed Looking at Another Rate Cut to Stem Crisis

By Neil Irwin
Washington Post Staff Writer
Tuesday, December 16, 2008

The Federal Reserve is widely expected this afternoon to cut interest rates for the 10th time in just over a year, driving the rate it controls close to zero as it continues the most sweeping effort to stabilize the economy in the history of the central bank.

The federal funds rate, at which banks lend to each other, is already at 1 percent. The Fed is expected to drop it to half a percent, or even lower, at the end of its policymaking meeting today. That would be the lowest U.S. rate on record.

Rate cuts, however, are not having the same impact that they normally have. Given the meltdown in world credit markets, no matter how low the rate goes, lenders are not passing the cuts to their customers.

As a result, the Fed is using every tool in its arsenal -- many of them newly invented -- to try to contain the damage of the financial crisis and steep economic downturn. Today, it may signal that it will further expand its unconventional lending programs, which already amount to about $2 trillion.

Since World War II, the nation has experienced 11 recessions, including the current one. Those downturns have had various causes -- too much inventory on businesses' books, for example, or the popping of a stock market bubble -- and rate cuts have routinely helped the economy get back on its feet.

This a more virulent downturn, with a simultaneous bursting of a global lending bubble, especially involving U.S. home mortgages. The result has been a breakdown in the credit flow of a sort that has historically occurred only in the rarest and most profound crises. By responding quickly and aggressively, the Fed is trying to avoid repeating the mistakes that policymakers have made in the past.

"Make no mistake, this is not a garden variety recession of the sort we've seen since World War II, when there were excessive manufacturing inventories or inflation or central bank tightening," said David Rosenberg, chief North American economist at Merrill Lynch. "We're all flying blind."

In 2001, there was a correction of the technology stock bubble and over-investment by businesses in the 1990s. Thanks in part to aggressive Fed rate cuts, it was a mild recession.

In 1990-91, a bubble in commercial real estate popped and savings and loans failed in vast numbers, but the breakdown in credit was mostly contained to those sectors.

The 1981-82 recession was the most severe of the post-World War II era, but was caused by the Federal Reserve, which aggressively raised interest rates to try to end the high inflation of the 1970s.

This downturn, by contrast, features the bursting of a mortgage lending bubble, a home price bubble, a consumer spending bubble, a commercial real estate bubble, and a corporate lending bubble. It has already brought down several of the world's largest financial companies, and many more would have gone under if it weren't for extraordinary government interventions to prop them up.

Part of what worries economists about this recession -- and makes them think that it could rival the 1981-82 recession in severity -- is the speed with which it has worsened in recent months.

Some credible forecasters expect the economy to shrink at a 6 to 7 percent annual rate in the final three months of the year, to continue shrinking through the first half of 2009, and for the jobless rate to hit 9 or even 10 percent before good times return.

"This is playing out in ways that we haven't seen in the postwar era," said Mark Gertler, an economist at New York University who is a leading scholar of business cycles. "That makes it really hard to predict."

Historically, economic downturns rooted in a collapse of credit availability have had more severe, long-lasting consequences than those with other origins. The most prominent examples are the Great Depression in the 1930s and in Japan in the 1990s. Japan experienced 15 years with effectively no economic growth.

Many economists are optimistic that the United States will avoid a worst-case scenario because policymakers are responding aggressively. But the risk is there.

"We went into this with a huge shock to the financial system, and that morphed into a consumer-led recession," said Robert A. Dye, a senior economist with PNC Financial Services Group. These dynamics are now reinforcing each other, with lenders refusing to make loans, contributing to a worsening economy, which causes more people to default on their loans and leads to even less credit being made available.

"We're now at that stage where we have so many compounding downdrafts in the economy that we're decelerating at an extremely rapid clip," Dye said.

At their core, recessions are the ugly process of fixing imbalances that have come about because of unwise decisions by businesses, individuals or government leaders (or, often, all three). People tend not to make the exact same mistakes repeatedly, instead finding new ones to make.

In 2001, for example, the imbalances resulted from vast over-investment in Internet, telecommunications and other technology sectors, coupled with a broader over-investment by businesses in new employees and equipment. But banks and other lenders suffered relatively little damage, so money continued to be made available for borrowing by individuals and non-technology businesses.

"The companies that went under in the 2001 downturn tended to be new, and didn't have a lot of backward linkages into the economy," said Andrew Tilton, a senior economist at Goldman Sachs. "Think about the automakers that are suffering now. They have enormous linkages back through the economy, through suppliers, dealer networks, that sort of thing."

Moreover, the Federal Reserve aggressively cut interest rates, helping to promote growth, and the Bush administration succeeded in pushing through large tax cuts. The result, by many measures, was a very mild recession. In fact, it likely wouldn't have been classified a recession at all if it hadn't been for the Sept. 11, 2001, terrorist attacks and subsequent economic distress.

The recent downturn with the most similarities to this one may be the recession of 1990-91. That one came about because of a huge commercial real estate bubble, the collapse of which brought down the entire savings and loan industry and many other banks, crimping credit more broadly.

But economists emphasize that the problem then was smaller. In 1990, the outstanding commercial real estate debt amounted to $818 billion, or about 14 percent of the nation's gross domestic product that year. In 2007, just before the current financial crisis, Americans owed $11 trillion in mortgage debt, or about 80 percent of the GDP.

Indeed, the 1990-91 crisis led to banking regulations that helped funnel more lending activity outside the banking system to complex securities.

"That's an important distinction," Gertler said. "In the early '90s, the problems were pretty much entirely in commercial banks and savings and loans, so the government could quickly go in, look at the books, and deal with the situation in a way that it couldn't today."