Zero Hour

The Fed has cut the chief lending rate to zero.

The Federal Reserve cut the main U.S. interest rate to “a target range” of between zero and 0.25 percent and said it will do whatever is needed to end the longest recession in a quarter-century and revive credit.

The Fed “will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” the Federal Open Market Committee said today in a statement in Washington. “Weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

Treasury notes rallied in anticipation the Fed will buy the securities to force borrowing costs for consumers and companies lower. Nine rate cuts in the prior 14 months and $1.4 trillion in emergency lending have failed to reverse the economic downturn.

“The focus of the committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level,” the FOMC said.

The statement noted that the Fed has already announced it will purchase agency debt and mortgage-backed securities, and said the Fed is ready to expand the program. The central bank said it continues to weigh the potential benefits of buying longer-term Treasury securities.

And the liquidity trap closes with a ghastly, echoing crunch, like something out of an Edgar Allen Poe story. We're in uncharted territory here. The other half of the Fed policy, just as expected, is to magically invent a crapload of money. Officially, the Fed has today signaled that the Japan Scenario is on.

The Bank of Japan has been the only major central bank in modern times to mix a policy of steep rate reductions with quantitative easing, or the strategy of injecting more reserves into the banking system than needed to keep the target interest rate at zero.

Japan’s central bank kept its main rate at zero from 2001 to 2006 while flooding the banking system with extra cash to encourage lending, spur growth and overcome deflation. The abundant funds failed to prompt lending by commercial banks, which expanded their reserves at the central bank almost nine times by early 2004.

So there we are. And much like Japan, the cure will be far worse than the disease. The Fed is turning on the faucet full blast in a desperate effort to stave off a deflationary depression spiral. But Japan's already high personal savings rate and low personal debt contributed mightily to their eventual freedom, it just took a decade to do it.

We have no such reserves to fall back on. Everything the Fed has tried so far has failed. We're down to the last card in the deck now, zero rate and unlimited fiat money. When this too fails to turn around the economy, what then?

We're now officially a third world economy.