Advertisement
Markets

Why Did the Fed Cut Rates to Near Zero?

The Federal Reserve's move won't impact the economy right away, but that's not the point

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.

Advertisement - Article continues below

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."

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.

Advertisement
Advertisement - Article continues below

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."

Advertisement - Article continues below

"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.

Advertisement
Advertisement

Most Popular

11 Dividend-Paying Stocks You Should Think Twice About
dividend stocks

11 Dividend-Paying Stocks You Should Think Twice About

Dividend-paying stocks often can be a store of safety, but 2020 has been difficult on income equities. These 11 picks look like shaky plays despite th…
September 21, 2020
Medicare Basics: 11 Things You Need to Know
Medicare

Medicare Basics: 11 Things You Need to Know

There's Medicare Part A, Part B, Part D, medigap plans, Medicare Advantage plans and so on. We sort out the confusion about signing up for Medicare --…
September 16, 2020
Where You Should Invest Now
investing

Where You Should Invest Now

Kiplinger.com senior investing editor Kyle Woodley joins our Your Money's Worth podcast to answer investor questions about tech stocks, the election a…
September 22, 2020

Recommended

Bonds: 10 Things You Need to Know
Investing for Income

Bonds: 10 Things You Need to Know

Bonds can be more complex than stocks, but it's not hard to become a knowledgeable fixed-income investor.
July 22, 2020
Best Bond Funds for Every Need
Investing for Income

Best Bond Funds for Every Need

In a changing market, it’s important to remember why we hold bonds in the first place.
September 15, 2020
Does a 40% Bond Allocation Make Sense in Today’s Portfolios?
retirement planning

Does a 40% Bond Allocation Make Sense in Today’s Portfolios?

For many investors, the short answer is no. Here’s why, and what you might consider instead.
September 7, 2020
Is the Stock Market Closed on Labor Day?
Markets

Is the Stock Market Closed on Labor Day?

The good news: Stock markets and bond markets alike get the day off for Labor Day. But traders don't get an early start to the weekend.
September 5, 2020