Fed may cut interest rates even more

The Federal Reserve is widely expected to cut interest rates again — and might even cut all the way to zero — to revive the economy. A 0.5 percentage point cut is expected at the central bank's Dec. 15-16 meeting, which would bring the target to 0.5 percent. That's the lowest level ever based on Fed records that begin in 1990.

Michael Feroli, a U.S. economist at JPMorgan, says fears of deflation will prompt a cut to zero by the Fed's Jan. 27-28 meeting. That rate will be held through 2009, he says.

Deflation, a recurring decline in prices, is rare but damaging to the economy and tough to get rid of. Consumers postpone spending as they expect prices to drop. This stunts economic growth, forcing companies to cut more jobs, which further pressures spending.

Low rates can stimulate economic growth. By making capital cheaper for banks, the Fed hopes they'll lend more, and encourage spending by consumers and businesses. So far low rates haven't done the trick; credit remains tight amid the financial crisis.

Moody's Economy.com economist Ryan Sweet says another Fed cut might not help much since the effective "real world" rate is already below the target.

The Fed's many liquidity programs are making the rate hard to control, says IHS Global Insight economist Brian Bethune. "These are not normal operating conditions," he says.

If the rate goes to zero, the Fed loses a key weapon in its arsenal. Sweet thinks it might first announce plans to keep the rate low for an extended period, with the aim of reducing long-term Treasury yields. This could push down rates on mortgages and other loans.

Sweet notes a zero percent federal funds rate would make it difficult for money-market funds to offer competitive yields. As a result, investors could pull money out of banks — which is not what the Fed wants, Sweet says.