Federal Reserve officials are weighing further interest-rate cuts, even if Congress passes a $700 billion rescue plan, in the face of a deteriorating economic outlook and severely strained financial conditions.
The Fed's willingness to consider additional cuts marks a turnaround from the past few months, when soaring food and energy prices turned its attention to inflation risks. At a regular September meeting, after oil prices had receded, officials still declined to move the central bank's federal-funds target rate from 2%.
A reduction in rates is still far from certain, in part because of inflation worries. But in just the past few weeks, as the credit crisis pummeled the financial system, economic data have become steadily worse, raising fears of a recession.
Rates are currently at 2%. Rates have dropped from 5.25% to 2% and we are currently in a credit crunch. The interest rate isn't the problem. The problem is is confidence in whoever you're lending to. If you think a borrower is about to goo bankrupt -- or may be bankrupt between the time you lend him money and the time he pays it back -- you're not going to make the loan. And that is exactly what is happening right now:
The cost of borrowing in dollars in London for three months rose for a fourth day, signaling that banks haven't started to lend after the U.S. Senate approved a $700 billion plan to rescue beleaguered financial institutions.
The London interbank offered rate, or Libor, that banks charge each other for such loans climbed 6 basis points to 4.21 percent today, the highest since Jan. 11, the British Bankers' Association said. The corresponding rate for euros advanced 3 basis points to a record 5.32 percent. The Libor-OIS spread, a gauge of cash scarcity among banks, widened to a record.
``We still see upward pressure on maturities from one week,'' said Patrick Jacq, a fixed-income strategist in Paris at BNP Paribas SA, France's biggest bank. ``The situation is still blocked and we're unlikely to see spreads decline before confidence has been restored.''
Credit markets have frozen as financial institutions hoard cash to meet future funding needs amid deepening concern that more banks will collapse. Libor, set by 16 banks in a daily survey by the British Bankers' Association, is used to set rates on $360 trillion of financial products worldwide, from home loans to derivatives.
This problem has nothing to do with interest rates. With the year over year inflation rate at 5.4% and the compound 3-month rate at 7.2%, interest rates are actually negative. In addition, the Fed has a ton of lending facilities in place that are flooding the market with money.
This is about confidence. And there is nothing the Fed can do about that.