Fed, in major shift, floods system with cash

John W. Schoen Senior producer • Profile • E-mail

This week's move by the Treasury and Federal Reserve to inject another $800 billion into the financial system opens yet another chapter in the government's continually evolving response to the financial crisis. But the announcement reflects a policy that has been evolving behind the scenes at the Federal Reserve for months with little fanfare.

Add one more acronym to the alphabet soup of financial rescue programs:  zero interest rate policy, or ZIRP. But ZIRP is not just another bailout program.

ZIRP represents a major shift in the Fed's monetary policy, which typically involves managing lending rates and adding or draining cash to the banking system. But the central bank is running out of room to lower interest rates, and banks are hoarding much of the fresh cash they have received from the Treasury. So the Fed is bypassing the banking system and pumping money directly into the financial system to try to revive economic growth.

So far it is hard to tell whether it is working. A fresh ream of reports out Wednesday was not encouraging.

Consumers cut spending by 1 percent during October, faster than at any time since the terrorist attacks of Sept. 11, 2001, according to one report. A separate survey showed that consumer confidence fell this month to a 28-year low.

O rders for costly durable goods like cars, machinery and computers tumbled a steeper-than-expected 6.2 percent in October. And t he Labor Department reported that 529,000 workers filed new claims for unemployment benefits in the latest week, a bit fewer than the week before but still a level generally seen only during recessions.

As nominal short-term interest rates have approached zero, the Federal Reserve under Chairman Ben Bernanke has injected hundreds of billions of dollars into the economy through a variety of programs, with varying degrees of success. Since early September, the value of assets held by the Fed has exploded from about $950 billion to more than $2.2 trillion — not including Tuesday’s announced purchases.

The Fed has offered little detail about the assets it is buying, making it difficult to estimate how risky or effective the moves will be. These massive investments are aimed at heading off a catastrophic downturn, although most economists believe the economy already is in the deepest recession in more than a quarter-century.

“We have a joint venture going on between the Treasury and the Fed to essentially create a  government-sponsored banking system, if I can call it that, to substitute for the private sector banking system that is not wanting to lend,” said Paul McCulley, an investment manager at PIMCO, the giant money management firm.

Until September, the Fed’s primary response to the credit crunch and weakening economy was to slash short-term interest rates — cutting its target bank lending rate to just 1 percent from over 5 percent as recently as last year. But those rate cuts have done little to unclog frozen credit markets or reverse the effects of a housing market collapse that has wreaked havoc on the economy.

On Tuesday the government reported the nation's gross domestic product shrank by a half-percent in the third quarter — the biggest drop since the 2001 recession. Consumer spending fell by 3.7 percent, the first decline since 1991 and the worst since 1980.

Even before those figures were released, economists were slashing their forecasts. On Friday, Goldman Sachs chief U.S. economist Jan Hatzius revised his estimates to show GDP falling at a 5 percent annual rate in the current quarter and unemployment rising to 9 percent by the end of next year from the current 6.5 percent.

"The U.S. recession is set to get worse — a lot worse — in the next couple of quarters,” said Nariman Behravesh, chief economist at IHS Global Insight in a note to clients Tuesday.

Behravesh estimates that if Congress and the Obama administration pass a new economic stimulus package worth $500 billion to $700 billion, it could add about 1 percentage point to growth in 2009 and 2010. But he says it’s probably won’t come soon enough to boost growth in the first half of 2009.

“We are in the early stages of one of the worst recessions in the postwar period, even factoring in a massive stimulus program,” he said.

MORE FROM EYE ON THE ECONOMY

Eye on the Economy Section Front

'Problem' banks at highest level in 16 years RV industry no longer running on empty Long-term unemployed face dwindling options  Obama warns of 'double-dip recession' One in four metro areas in recovery mode Geithner warns lack of loans may slow recovery Of bats and billions: Following stimulus funds As stimulus funds trickle down, debate heats up Commercial real estate bust looms NYT: Ex-homeowners forced into shelters Eye on the Economy Section Front   Add Eye on the Economy headlines to your news reader: