Fed sets historically low interest rate

From the Wall Street Journal:

WASHINGTON -- U.S. Federal Reserve officials on Tuesday slashed official interest rates to an historic low range to combat a deepening recession and signaled they will keep rates "exceptionally low" for some time amid rapidly waning price pressures.

Officials also signaled a new phase for policy in which lending programs financed by the Fed's ballooning balance sheet, a process known as quantitative easing, replace the federal funds rate as the Fed's primary policy tool.

The Federal Open Market Committee voted unanimously to reduce the target fed funds rate for interbank lending from 1% to a range of zero to 0.25%, the lowest since the Fed started publishing the funds target in 1990. The market-determined effective fed funds rate already has already hit record lows in recent weeks. (Read the Fed's statement.)

Economists had expected a smaller cut of just 0.5 percentage point, and hadn't envisioned the Fed setting a range.

"The Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time," the Fed said, adding it will "employ all available tools' to promote growth and maintain price stability.

The Fed has used a variety of operating targets through the decades, including the discount rate and monetary aggregates.

The Fed also lowered the discount rate paid by commercial and investment banks for Fed loans by 0.75 percentage point to 0.5%.

In a statement, the FOMC said its focus "will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level."

Ben Bernanke tipped the shift toward quantitative easing -- in which cash is essentially created and used to finance lending facilities -- earlier this month. He said that while the Fed's ability to use interest rates to support the economy "is obviously limited" with rates so low, the "second arrow in the Federal Reserve's quiver -- the provision of liquidity -- remains effective."

This is getting into what Paul Krugman has described as "The Return of Depression Economics." From a review of his book by that name, here is what Krugman means by Depression Economics.

Krugman does not think the world is about to descend into a 1930's-style depression. In fact, he argues that such a fate can be avoided if we instead remember the economic theories born of the Depression, most notably the work of Lord Keynes. Depression economics, Krugman says, ''is the study of situations where there is a free lunch, if we can only figure out how to get our hands on it, because there are unemployed resources that could be put to work.'' He thinks that in some places, most notably Japan, it is time for government to actively seek inflation.

...Krugman argues that now, as in the 1930's, there is too much emphasis on economic orthodoxy and on somehow restoring the confidence of investors. To be sure, confidence is of immense importance at certain times, and a major reason that country after country suffered currency collapses was that investors took flight. But countries facing crises now are not going to be any more successful than Herbert Hoover was at winning confidence by slashing public works spending while their economies stagnate.

What appalls Krugman now is not the problems the world faces but the reluctance to learn from them. ''Those who worried about balanced budgets back when uncontrollable deficits were the problem suddenly insist that raising taxes and cutting spending will actually prevent a recession, because it will improve confidence,'' he says. ''Those who wanted stable prices back when inflation was the risk now claim that 'managed inflation' will somehow backfire.''

The reality to Krugman is that there are few, if any, economic policies that are always right for all countries. What you should do depends on where you are and on an ability to think clearly about how you got there. There are times when capital controls can work, and when they would be disastrous. There are times when fixed exchange rates can work wonders, and times when they can blow up. That is not the easy answer, but it is the right one.

Krugman's book has been updated and reissued this month. The updates include

~ The failure of regulation to keep pace with an increasingly out-of-control financial system
~ Steps that must be taken to contain the crisis (a rarity in the spate of books coming forth in response to the failing economy)

The economic rules that the Republican Party has been spouting since Reagan was elected will NOT be helpful now that they have caused the greatest Recession since the Great Depression.