Fed's big rate cut just for starters

WASHINGTON — The Federal Reserve entered a new era on Tuesday, lowering its benchmark interest rate virtually to zero and declaring that it will now fight the recession by pumping out vast amounts of money to businesses and consumers through an expanding array of new lending programs.

Going further than anticipated, the central bank cut its target for the overnight federal funds rate to a range of zero to 0.25 percent — levels that Japan used in the '90s in its own fight against deflation.

Though important as a historic milestone, the move is largely symbolic. The funds rate, which affects what banks charge for lending their reserves to each other, had already fallen to nearly zero in recent days because banks have been so reluctant to do business.

Of much greater practical importance, the Fed bluntly announced that it would print as much money as necessary to revive the frozen credit markets and fight what is shaping up as the nation's worst economic downturn since World War II.

In effect, the Fed is stepping in as a substitute for banks and other lenders and acting more like a bank itself. "The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth," it said. Those tools include buying "large quantities" of mortgage-related bonds, longer-term Treasury bonds, corporate debt and even consumer loans.

In response, most banks cut the rate they charge their best customers, known as the prime rate, to 3.25 percent from 4 percent. The last time it was that low was in 1955, according to data from the Federal Reserve Bank of St. Louis.

In short order, the move is expected to lead lower rates on existing adjustable-rate home-equity loans tied to the prime rate. Federal Reserve statistics show that commercial banks hold $580 billion in revolving home-equity loans on their balance sheets.

Analysts said mortgage rates may also tumble to 5 percent or lower, from the current average of 5.3 percent on Tuesday, as a result of the Fed's rate cut and its renewed pledge to buy up billions of dollars of mortgage debt. With rates that low, a new boom in refinancing is expected.

Taken together, these moves could put billions of welcome and unexpected dollars into the pockets of consumers at a time when a recession has zapped American's will to spend.

"Not only does it help in reducing the actual borrowing costs — home-equity loans, credit cards or your auto loan — but it improves the affordability, so more people are eligible for credit because their interest payments are lower," said Brian Bethune, chief financial economist for Global Insight.

He said that will help improve chances that borrowers with borderline eligibility will qualify for loans.

The move came as President-elect Obama summoned his economic team to a four-hour meeting in Chicago to map out plans for an enormous economic-stimulus measure that could cost anywhere from $600 billion to $1 trillion over the next two years.

The two huge economic-stimulus programs, one from the Federal Reserve and one from the White House and Congress, sets the stage for a powerful but potentially risky partnership between Obama and the Fed's Republican chairman, Ben Bernanke.

"We are running out of the traditional ammunition that's used in a recession, which is to lower interest rates," Obama told reporters at a news conference on Tuesday. "It is critical that the other branches of government step up, and that's why the economic-recovery plan is so essential."

Financial markets were electrified by the Fed action. The Dow Jones industrial average jumped 4.2 percent, or 359.61, to close at 8,924.14. Investors rushed to buy long-term Treasury bonds. Yields on 10-year Treasurys, which have traditionally served as a guide for mortgage rates, plunged immediately after the announcement to 2.26 percent, their lowest level in decades, from 2.51 percent earlier in the day.

For the moment, Obama and Bernanke appear to be on the same page, though that could abruptly change if the economy starts to revive. Fed officials have already assumed that Congress will pass a major spending program to stimulate the economy, and they are counting on it to contribute to economic growth next year.

In more normal times, the Federal Reserve might easily start raising interest rates in reaction to a huge new spending program, out of concern about rising inflation.

But data on Tuesday provided new evidence that the biggest threat to prices right now is not inflation but deflation.

The federal government reported Tuesday that the consumer price index fell 1.7 percent in November, the steepest monthly drop since the government began tracking prices in 1947. The decline was largely driven by the recent plunge in energy prices, but even the so-called core inflation rate, which excludes the volatile food and energy sectors, was essentially zero.

Obama's goal is to have a package ready when the new Congress convenes on Jan. 6, so he can sign it into law soon after he is sworn into office two weeks later.

Material from The Associated Press was used in this report.