Why Did the Fed Cut Rates to Near Zero?

The Federal Reserve on Sunday announced a steep cut to short-term interest rates, as well as a commitment to buying several hundred billion dollars of longer-term debt to lower long-term rates.

Cutting rates to near zero and launching a so-called quantitative easing program are moves straight out of the Fed's playbook from the Great Financial Crisis.

The question, then: Why is the Fed using the same moves today when the economy is reeling for very different reasons? After all, the financial system is seizing up because of a demand shock, not a credit crisis. Easy money in the form of cheap mortgages and car loans won't make it safe for folks to venture out of their homes.

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But that's not what the Fed was trying to achieve when it dropped the Fed funds rate, its benchmark interest rate, by a full percentage point to a range of 0% to 0.25%.

Rather, in the words of University of Oregon economist and Fed expert Tim Duy, "It was time to go big or go home." (opens in new tab)

The Fed already took steps to stabilize the government bond market last week when it wasn't functioning well because of a lack of liquidity. (Liquidity allows market participants to buy or sell securities when they want at close to the prices they want.) The central bank made $1.5 trillion in short-term loans available to bond dealers and launched a wave of Treasury purchases.

By following those initiatives with a massive rate cut and QE program, the Fed sent a critical message to investors, says Duy: "The aim is to act as a buyer of last resort following the deterioration in liquidity across the Treasury market. The Fed basically signaled as clear as it could that it was ready to backstop the financial markets."

"I am thinking (Fed chief Jerome) Powell is not going to let another Lehman Brothers happen on his watch," Duy adds.

Powell admitted Sunday night that the rate cuts wouldn't have an impact on the economy at this time. That's not the intent. Monetary policy is limited in what it can achieve when the issue is a demand shock.

What will help right now is accommodative fiscal policy. In plain English, that means the president and Congress need to step up and approve spending programs that can help blunt the impact of this disaster. Loose monetary policy can support fiscal policy by lowering the government's borrowing costs with ultra-low interest rates. For example, the yield on the 10-year Treasury note stands well below 1%.

"In the near term we really need fiscal stimulus," says Duy. "The Fed has paved the way, but they can’t make Congress and the president follow their lead."

The Fed's rate-cutting actions aren't meant to have much visible impact now. They're intended to help us rebuild once the war against COVID-19 is over.