Can Fed cut enough to help?

Central bank is set to slash key interest rate to spur lending. If that doesn't work, few options remain

WASHINGTON -- With the country sliding deeper into recession, the Federal Reserve is ready to slash its key interest rate, perhaps to an all-time low. By doing so, the agency hopes to ease the economic pressures felt by many Americans.

To battle the worst financial crisis since the 1930s, Fed Chairman Ben Bernanke and his colleagues have already ratcheted down their main lever for influencing the economy, the federal funds rate, to 1 percent, a level seen only once before in the last half-century.

The Fed opens a two-day meeting today to assess the economy and decide its next move on rates. Another reduction to the funds rate, the rate banks charge each other on overnight loans, is expected to be announced Tuesday.

Many economists predict the Fed will cut its rate in half, to just 0.5 percent. A few think the Fed could opt for an even more forceful action and lower the rate by three-quarters of a percentage point or more. A cut that large would bring the rate to its lowest point on records that go back to 1954.

But even an aggressive rate reduction won't by itself turn the economy around, analysts say.

"It is not so much going to give the economy a big push forward," said Stuart Hoffman, chief economist at PNC Financial Services Group. "It's more a case of trying to help the economy from being pushed further backward by all these negative events."

However deeply the Fed decides to cut rates, the prime rate for many consumer and small-business loans would drop by a corresponding amount. The prime lending rate, now at 4 percent, is used to peg rates on home equity loans, certain credit cards and other consumer loans. Lower rates could give pinched borrowers some relief.

The goal of lower borrowing costs is to entice people and businesses to spend more, which would revive the economy. So far, though, the Fed's aggressive rate reductions have failed to lift the country out of the recession that started last December.

Clobbered by the financial crisis, worried banks have hoarded their cash and been extremely reluctant to lend money to customers. Fearful consumers, watching jobs vanish and their investments tank, have sharply cut back their spending.

The negative forces have fed off each other, creating a vicious circle that Bernanke and Treasury Secretary Henry Paulson have been desperately trying to break.

To unlock lending and get financial markets to operate more normally, the U.S. has resorted to a string of radical actions, including a $700 billion financial bailout in which the government is making cash injections into banks in return for partial ownership stakes.

Dwindling options

In terms of rate cuts, the Fed is getting ever closer to running out of ammunition.

It can lower the funds rate only so far -- to zero. Whether that should happen is a point of debate among economists. And even if it were to happen, the prime rate would fall to 3 percent but no lower.

Against that backdrop, Bernanke says the central bank is exploring other ways to stimulate the economy.

The Fed could buy longer-term Treasury or agency securities on the open market in substantial quantities, Bernanke says. This might lower rates on these securities and help spur buying appetites.

Another option the Fed has considered is issuing its own debt, which would give the central bank cash and more flexibility to battle the financial crisis. To do that, however, the Fed would need new powers from Congress.

"The Fed wants to show that it has tools and options and is not out of tricks because interest rates are very low," said Michael Feroli, an economist at JPMorgan Economics. "The problems holding back the economy are fairly long-lived in nature."

To combat the financial crisis, the Fed has already created first-of-a-kind programs, such as getting cash directly to companies by buying up mounds of "commercial paper," the short-term debt firms use to meet everyday expenses such as payroll and supplies.

It also recently launched massive programs to boost the availability of consumer credit, including that for cars, student loans, homes and credit cards.

The Fed is also making loans to banks and providing a financial backstop to the mutual fund industry, and it has injected billions of dollars into financial markets in the U.S. and abroad.

The Fed could opt to expand programs by enlarging loans it is now making, providing loans to other types of companies or buying more and different types of debt. The Fed's balance sheet has ballooned to $2.2 trillion, from close to $900 billion in September, reflecting some of those other activities to get credit flowing again.