After rate cuts: The Fed's new ball game

With rate cuts doing little to help boost the economy, the Fed has begun to print money to finance its liquidity programs. But that could spell disaster down the road.

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By David Goldman, CNNMoney.com staff writer

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NEW YORK (CNNMoney.com) -- After what is likely to be the last in a long series of interest rate cuts Tuesday, the Federal Reserve is expected to continue its new, perhaps more effective monetary strategy: printing lots of money.

The Fed traditionally uses its rate-cutting tool to encourage lending and boost the economy. But despite a staggering 4.25 percentage points of cuts since September 2007, the economy has not improved - in fact, it has gotten worse, drifting in to a recession last December.

Economists expect the Fed to produce one more cut to its benchmark funds rate at the conclusion of its Federal Open Market Committee meeting Tuesday, trimming the rate to 0.5%, the lowest level on record. Whether one last rate cut will help stimulate economic growth remains to be seen.

At any rate, the Fed will likely continue to use its new favorite tool, quantitative easing, "Fed-speak" for pouring new money into the economy.

In addition to lowering rates, the Fed has increased its lending to financial institutions and foreign central banks throughout the year to ease the credit crunch. But when the financial markets exploded into crisis-mode in mid-September, the Fed's reserve of Treasurys to support its lending began to run low. As a result, the central bank began firing up the printing presses, financing drastically increased lending to banks, purchases of corporate debt and bailouts of troubled institutions like AIG (AIG, Fortune 500).

As a result, the Federal Reserve's balance sheet has exploded since mid-September, more than doubling to $2.3 trillion from less than $1 trillion before Lehman Brothers' collapse ignited the lending crisis.

The huge increase in Fed lending has helped to ease credit, encouraging private institutions to lend on their own. Perhaps the best example of this trend can be seen in the commercial paper market, which is short-term corporate debt that companies sell to investors. That key market dried up after Lehman's bankruptcy, but the Fed was able to restore it to health by purchasing more than $300 billion of paper. Private investors have followed, outpacing the Fed's weekly purchases for three weeks in a row.

The Fed may look to quantitative easing as a way of boosting the housing market. By buying up 10-year Treasurys in large volume - essentially the government buying up its own long-term debt - the Fed could help to lower mortgage rates for prospective homebuyers.

Thirty-year fixed rate mortgages, which have historically moved in step with the 10-year note, currently hover around 5.5% despite 10-year Treasury yields of about 2.5%. Before the credit crunch, the rates were more typically within a range of 1.5 to 2 percentage points from one another. Economists say printing more money to help lower mortgage rates may get at the crux of the problem facing the economy.

"The combination of low home prices and low mortgage rates will make home affordability so much higher," said Bernard Baumohl, chief economist for the Economic Outlook Group. "Ultimately, housing is the epicenter that's holding back the banks and the economy from growing."

Buying up droves of Treasurys may also help encourage banks to lend, as government yields dip even lower into already historic lows. Gaining little return on those investments, banks may be forced to return to their traditional money-maker, issuing loans.

The downside: inflation

But there is a dark side to quantitative easing: inflation. The government has backed all of this new debt by selling Treasurys, which have been the golden asset of the credit crisis. They have been the only liquid security of late, reaching historic highs as their yields have hit all-time lows.

But there will come a time when the stock market bounces back and investors will no longer be satisfied with such low returns on their investments.

"Everybody and their brother knows this has to come down some time," said Kim Rupert, fixed income analyst with Action Economics. "It's tough to continue to buy Treasurys at these unsustainable levels."

That would mean huge amounts of government debt with little demand left to buy it, resulting in a devaluing of the dollar.

"The end result of all of this could be the next major problem: the crisis of confidence in the dollar," said Baumohl. "At some point, foreign investors are not going to come to the table to buy U.S. debt, leading to a dollar decline."

The dollar has held up very well throughout the credit crisis despite very low interest rates. But with countries like China and Middle Eastern countries with export-based economies facing a crisis of their own, those huge purchasers of U.S. government debt may start to ask for more return on their investment before they look elsewhere.

"That won't happen until about 2010," Baumohl said. "Right now, people are just so nervous about the credit markets, they'll continue to buy Treasurys even with rates at ridiculously low levels."

Bonds rise, rates fall

Treasurys continued to rise Monday as industrial production slid again, a sign that the economy will not rebound from the recession any time soon.

The benchmark 10-year Treasury was up 19/32 to 110 27/32 and its yield dipped to 2.51% from 2.57% from late Friday. Bond prices and yields move in opposite directions.

The 30-year rose 2 5/32 to 130 9/32 and its yield dipped to 2.95% from 3.05%, dropping below 3% for the first time in its history.

The 2-year note rose 1/32 to 100 31/32 and its yield dipped to 0.75% from 0.77%.

The yield on the 3-month note was 0.02%, and has been hovering around 0% for days. Yields near the zero mark on short-term bills are an indication that investors are completely risk-averse, putting safety at a priority above profit.

The Treasury Department said its auction of $27 billion of 6-month notes Monday was well-received, with $73 billion in open interest. The median yield for the notes was 0.17%, and the yield traded at 0.2% later in the afternoon.

Meanwhile, lending rates between banks continued to sustain record low levels. The overnight Libor rate held 0.12%, and the 3-month Libor rate fell to 1.87% from 1.92% late Thursday, according to Bloomberg.com.

Libor, the London Interbank Offered Rate, is a daily average of what 16 different banks charge other banks to lend money in London, and is used to calculate adjustable-rate mortgages. More than $350 trillion in assets are tied to Libor.

Two market gauges showed confidence edging higher.

The "TED spread" narrowed to 1.85 percentage points from 1.89 percentage points Thursday. The TED spread measures the difference between the 3-month Libor and the 3-month Treasury bill, and is a key indicator of risk. The higher the spread, the more unwilling investors are to take risks.

Another indicator, the Libor-OIS spread, narrowed to 1.55 percentage points from 1.62 percentage points. The Libor-OIS spread measures how much cash is available for lending between banks, and is used for determining lending rates. The bigger the spread, the less cash is available for lending. To top of page

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