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Tuesday, December 16, 2008

Fed further slash interest rates on Tuesday

A surprised Wall Street bolted higher Tuesday after the Federal Reserve's historic decision to further slash interest rates and pledge broad support to revive the troubled US economy.

The Dow Jones industrials surged to 359.61 and closed at 8924.14, or 4.2 percent, and broader indexes jumped more than 5 percent after the central bank said it will use "all available tools" to jump-start the economy. It also set its target for the rate at which banks lend to each other to a range of zero to 0.25 percent, the lowest level on record.

Demand for long-term government bonds increased and pushed yields to record lows.

The promise of further government action and a Swiss-army-knife approach for mending the economy damped concerns that policymakers were running low on tools to fan the economy by further lowering interest rates.

The idea that the Fed will likely proceed with plans to snap up government and mortgage debt made it easier for investors to place bets that the central bank will do what is necessary to help bring an end to the longest recession in a quarter-century.

For the first time in its history, the Federal Reserve has set a target for short term interest rates as low as zero percent. The moves signals that the central bank has entered a new phase in its campaign to revive a battered U.S. economy.
If the interest rates go to zero, does it mean that everyone get to borrow money for free?
No. Pushing the federal funds rate down to zero doesn’t mean everything comes with zero-percent financing. It means banks can now raise cash — for very short periods — without paying interest.
Think of the Fed's target as the wholesale price of money. Banks and other lenders will still charge more than zero interest when they lend it to you and me. That’s how banks make money. But borrowers with very good credit will be able to get a great deal on a short-term loan.
The problem is that with the economy shrinking, businesses cutting back and banks worried about getting their money back, lenders have become stingier about providing credit. To get the economy moving again, the Fed typically cuts the cost of money to encourage more borrowing.

If it can’t cut rates below zero, what does the Fed do now?
It shifts gears. Plan B involves flooding the economy with trillions of dollars in cash, which the Fed began doing in September. Through a variety of special “facilities” the Fed has been buying up debt that no one else wants to buy. It’s already bought more than $1 trillion worth and says it plans to buy more.
This is called “quantitative easing.” It means the Fed makes money easier to get by providing it in vast quantities. The hope is that now that battered banks have been pulling back from the aggressive lending that got us into this mess, all this money sloshing around in the system will find its way into the hands of businesses and consumers that are having trouble getting loans.

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