Fed May Signal Other Steps Besides Interest-Rate Cut

The Federal Reserve is expected to cut interest rates to close to zero on Tuesday and may point to further unconventional steps to battle a year-old recession.

Economists expect the US central bank to lower its target for benchmark overnight rates by at least a half-percentage point to 0.5 percent and clearly state it will deploy so-called quantitative easing measures to restore growth.

The Fed on Monday said US industrial production fell 0.6 percent in November, with manufacturing output shrinking 1.4 percent to put it 7.3 percent below its year-ago level. A separate index of manufacturing activity in New York state hit a record low in December.

The data offered a fresh sign that an already year-old U.S. recession is deepening, and underscores the case for aggressive and unconventional actions by the central bank's policy-setting Federal Open Market Committee.

Some economists expect US output to shrink at a 6 percent annual pace or more in the fourth quarter.

"Since there is precious little room between current target rates and zero, it will be more interesting to see if the FOMC statement begins to lay out any additional steps that might be undertaken in the new quantitative easing regime," said Max Bublitz, chief strategist at SCM Advisors in San Francisco.

Quantitative easing, which recalls the emergency steps taken by Japan to expand the supply and circulation of money to end a deflationary decade of stagnation in the 1990s, was discussed by Fed Chairman Ben Bernanke in a speech on Dec. 1.

"Our nation's economic policy must vigorously address the substantial risks to financial stability and economic growth," the Fed chief said.

Bernanke said the Fed could directly intervene in markets to stimulate the economy, saying it could purchase U.S. government bonds to drive down yields or private sector debt to narrow spreads and lower borrowing costs.

With yields on U.S. Treasury debt already very low, economists say the Fed may get better results by aiming at mortgage-backed securities. Increasing demand for these bonds should help to reduce mortgage rates, spurring demand for homes and hopefully halting the slide in housing prices.

The housing collapse has led to the worst financial crisis since the Great Depression and tipped the U.S. economy into recession last December. The downturn is already the longest since the 1980s, and economists hold out little hope for an upturn before mid-2009.

The Fed has already reduced the overnight federal funds rate 4.25 percentage points to 1 percent since September 2007.

It also has engaged in a degree of quantitative easing by pumping over $1 trillion into financial markets through a range of emergency liquidity facilities that it decided not to immediately sterilize, or withdraw, via daily operations.

This decision has seen the size of the Fed's balance sheet almost double from a year ago to $2.2 trillion.

Sterilization of Fed cash injections is normal practice to prevent excess money supply growth from stoking inflation, but that seems a like a distant problem at the moment.

In fact, some economists predict that the United States could suffer a deflationary period of its own in 2009, as tumbling oil and commodity prices, alongside increasing slack in the economy, deliver a sustained fall in general prices.

© 2009 CNBC.com