Illinois Pols, Cash Must Come Out of the Closet: Amity Shlaes
Commentary by Amity Shlaes

— It probably comes as a surprise to some that now a fourth Illinois governor is facing jail time. Governor Rod Blagojevich was arrested this week by U.S. Attorney General Patrick J. Fitzgerald for allegedly trying to sell the president-elect’s Senate seat.

But the surprised don’t include people from Illinois. Illinois people know the state has two kinds of politicians. One is the Abe Lincoln kind. The other is the Richard J. Daley kind, after the legendary “boss” who ran Chicago as mayor from 1955 until his death in 1976. These two types are less different than they seem.

The Lincoln kind is usually tall, usually an egghead, impossibly moral, and always a reformer. In this class stood hulking Paul Douglas, almost 6-feet, 3-inches. Senator Douglas saved the Indiana Dunes from development, led lawmakers on Capitol Hill in integrating their office staffs, and joined the U.S. Marines as a private at age 50 to show his patriotism.

Yet another in the Lincoln line was Adlai Stevenson II, the U.S. ambassador to the United Nations who stood up against the Soviet Union during the Cuban Missile Crisis. Stevenson famously continued to wear a shoe even after he’d worn a hole in its sole by campaigning so hard. President-elect Barack Obama aspires to fall into this category.

Running Into Trouble

This first sort represent Illinois, often outside Illinois. The second sort run Illinois.

And they run into trouble, at least most of the time. Richard J. Daley, the current mayor’s father, clashed loudly with reforming Democrats from his own party. The early 1970s brought the conviction of Otto Kerner, a former governor and federal judge. While governor, Kerner acquired shares in a race track association and then helped its owner secure favorable dates for races.

More recently there is the sad case of George Ryan. He won the attention of many of us in early 2003 for reviving the gubernatorial pardon and commuting the sentences of 167 people on death row. Now parked in prison in Terre Haute, Indiana, Ryan was convicted of illegally steering contracts in exchange for favors.

A third governor to go to prison was Dan Walker. In his youth Walker was a crusading lawyer who made his name documenting the very real brutality of the first Mayor Daley’s police at the Democratic National Convention in Chicago in 1968. Then Walker ran for governor in a blue work shirt as an anti-Machine candidate. But after his term in Springfield, Walker was convicted of fraud involving a failing savings and loan. In other words, Walker belonged, by turns, to both categories.

And of course there are those in this second category who win the race to the grave without a pit stop in prison. Richard J. Daley himself was one. Another was a former Illinois secretary of state, Paul Powell. At Powell’s death, the New York Times reported, the governor actually placed guards outside the official’s office to keep staff from removing documents.

Cash in Boxes

Then Powell’s executor found $800,000 in shoe boxes in Powell’s closet at the Hotel St. Nicholas. “I have tried as hard as I can to find where the money came from,” the embarrassed man — a university chancellor, no less — said.

There’s something wrong with this dynamic of public angels and closet crooks.

For one thing, the Lincoln line’s idealism limits its success. Stevenson lost both of his presidential campaigns against Dwight Eisenhower. He himself explained why: “Governor Stevenson, all thinking men are for you,” a voice in a crowd is said to have cried out. “Yes,” the governor replied. “But I need a majority to win.”

For another, the two categories do blur, as the above pictures suggest. Some who fell afoul of the law also do a lot of good — Ryan’s death row moves, Mayor Richard J. Daley’s city management. Some who hang with the old crowd, or come out of it – – the sons of the old mayor — are reformers.

Fickle Voters

Voters are fickle. First they cheer the prosecution of the politicians. Then they turn around and re-elect the prosecutor’s dream targets. If showy trials actually reestablished the rule of law, then Illinois would be all cleaned up by now, just like the waters of Lake Michigan. But the 78-page-length of Fitzgerald’s complaint suggests that little has changed since they dragged out Powell’s shoe boxes.

Another problem is that we fail to remember that prosecutors can be wrong. Fitzgerald’s New York corollary, Eliot Spitzer, fell as spectacularly as a statue of Stalin. With the revelations of Spitzer’s personal errors have come second thoughts about the worthiness of his prosecutions.

In Illinois, the preoccupation with scandalous business has made it more difficult to pass reform that serves legitimate business.

Though it’s hard to remember when you’re reading about Blagojevich’s efforts to place his wife on corporate boards, Illinois is in a budget crisis. Pensions of employees of one its biggest companies, the Tribune Co., are in jeopardy. Yet Topic A is that Blagojevich tried to silence a Tribune editorialist.

In short, sure, pull the pols and their wads out of their closets. But remember, especially now, as the states queue up for their bailouts, that there are all shades of error committed each day in our states. And most of those are better addressed in the state house than at a prosecutor’s press conference.

New $3 Trillion Bailout Is Coming to the Masses: Kevin Hassett
Commentary by Kevin Hassett

Dec. 15 (Bloomberg) — Pollster Frank Luntz asked a large audience at a conference in Washington last week to raise their hands if they had received a government bailout. While they chuckled and rested their hands on their laps, Luntz made an important observation. Bailout money is snowing down in an unprecedented blizzard, and if the moves fail to stimulate the economy, there will be a lot of angry voters.

Perhaps the same realization moved President-elect Barack Obama’s economic advisers to begin considering a bailout for the masses.

If Luntz asks the same question a few months from now, everyone may well lift their hand.

Bloomberg News last week reported that the chairman- designate of the National Economic Council, Lawrence Summers, had been conferring with conservative icon and Columbia Business School Dean Glenn Hubbard about a housing plan Hubbard designed with Columbia colleague Christopher Mayer. Obama’s economic advisers appear to have embraced the proposal, which is already “on a fast track at the Treasury,” according to the story.

The Hubbard-Mayer plan calls for the government to revive the moribund housing market by providing just about everybody with access to a 30-year fixed-rate mortgage with a 4.5 percent interest rate. That’s almost a full percentage point lower than the average national rate of 5.47 percent currently.

Buyers could borrow as much as 95 percent of the value of the home they purchase. The plan might extend to those with existing mortgages, allowing them to refinance and get the same terms. When either type of deal is complete, the lender will place the loan with Fannie Mae or Freddie Mac.

Splitting the Loss

Anyone refinancing with positive equity in their home would be relatively easy to accommodate. For those with negative equity — meaning the dollar amount of their mortgage exceeds the value of their house — Hubbard and Mayer recommend that homeowners and lenders split the loss evenly and start over with a clean mortgage reset to reflect the property’s current market value.

With some forecasts for fourth-quarter gross domestic product growth inching toward negative 8 percent at an annualized rate, drastic policy measures are becoming increasingly palatable.

This mortgage plan is radical, and might just be powerful enough to help turn this troubled economy around.

The bottom line: if you have a mortgage, this plan would put extra money in your pocket.

Imagine, for example, that you have a $500,000 mortgage with a 30-year fixed-rate loan carrying an interest rate of 6.1 percent, the average rate for a fixed 30-year mortgage issued this year. Lowering the interest rate to 4.5 percent would reduce monthly payments by about $500 monthly. Someone with a mortgage of $150,000 would save about $150 a month.

Better Than Rebates

These monthly payments changes are different from tax rebates because they would last for many years. For that reason, consumers would be fairly likely to increase their spending. After all, if your monthly housing expenses just dropped by $400, then adding a new car payment of $300 a month might seem a lot less frightening, even in these difficult times.

These subsidized mortgages should increase the number of home buyers and help push property values back up. There are a lot of problems in the economy, but they all began in the housing sector and it seems likely that staunching the bleeding there is a prerequisite for achieving financial stability.

Make no mistake, this remedy will be costly.

$3 Trillion

Last week’s report suggests that the Obama team may be wary of allowing everyone access to this plan, since it costs so much — $3 trillion by one recent estimate. One constraint being discussed is to disallow refinancing, limiting the program to home buyers.

The restriction will be impossible to impose, however. All that you would need to do to qualify for the 4.5 percent rate would be to find a “bailout buddy” and agree to purchase each others’ homes with the new low-rate loan. You could then either swap the homes back, or agree to rent the homes to each other for the same fee.

Also, the program will have the largest possible effect on home prices, a key target of the policy, only if borrowers expect it to last a long time. After all, if the person you sell your house to in the future has to borrow at a high interest rate to finance the purchase, then he will offer a lower price. That realization should affect the price you are willing to pay today.

Thus, the cost will be steep for two reasons. It will be tough to limit the new mortgage to home buyers, and the program will have to be sustained for a long time.

In the past, steep costs would have killed such a bill. But in today’s environment, it has almost become a political necessity to give voters their bailout too.

Ladies and gentlemen, grab your bailout buddy, help is on the way.

Central Banks Can Do Better Than Just Mopping Up: Caroline Baum

Dec. 11 (Bloomberg) — Central banks care about financial stability.

Asset bubbles can be financially destabilizing.

Therefore, central banks care about asset bubbles.

If only policy makers found this syllogism persuasive.

Until now, central bankers pretty much cared about asset bubbles only to the extent that asset prices affected their ability to deliver price stability and, in the case of the Federal Reserve’s dual mandate, maximum employment. Otherwise, the operative doctrine was laissez-faire-’til-after-they-burst.

That’s about to change, said William White, who recently retired from the Bank for International Settlements, where he was economic adviser and head of the Monetary and Economic Department from 1995 to June 2008.

“The most calamitous downturns were not preceded by any degree of inflation,” White said in a telephone interview yesterday. “There was no inflation in 1873-74, in the 1920s, in the 1980s in Japan and in the 1990s in Southeast Asia.”

All these extended credit cycles ended badly. The U.S. economy contracted for 65 months, a record, from 1873 to 1879.

The bursting of the housing bubble and the deepening financial and economic crisis should be sobering to those who resist the idea that asset bubbles, when they burst, can be as destabilizing as inflation, which is the reason central bankers adopted inflation targets.

In Denial

Central banks are still holding the line, at least publicly, on the inappropriateness of “targeting” asset prices, which misrepresents the issue. (More on that later.) Federal Reserve Vice Chairman Don Kohn said in a speech last month that he had reexamined the evidence and had came to the conclusion that he agrees with Alan Greenspan, his former boss and long-time advocate of bubble mop-up.

Bank of England policy makers are equally dug in, with Andrew Sentance, Charlie Bean and Sir John Gieve all arguing in recent speeches that using monetary policy, or interest rates, to “lean against the wind” is inadequate or inappropriate.

All these arguments miss the point. No one is suggesting central bankers target asset prices (Dow 13,000?). Nor is the issue bubble detection or identification, which implies policy makers know the appropriate level for asset prices and inspires visions of Sherlock Holmes-like characters looking under rocks in the hopes of making a discovery.

Economics is a social science. Econometric models spit out results that lack the accuracy of chemistry experiments and the precision of mathematical equations.

Asset Prices as Symptom

Central bankers are forced to deal in the realm of the touchy-feely all the time. If their work could be reduced to an equation, we wouldn’t a) need them or b) find ourselves in the mess we’re in now. So why is it so hard for policy makers to grasp what White and his BIS colleagues have been saying for a decade?

“Targeting asset prices is not at all what we’ve been suggesting,” White said. “Asset prices are a symptom. The underlying problem is excess credit growth.”

Too much effort goes into differentiating this asset bubble from the rest: what White calls “the school of what’s different: the CDOs, CDO-squareds, the SIVs, the rating agencies.”

It makes more sense to focus on “the school of what’s the same, and that’s the credit cycle. There’s always something new, but there’s always something the same: leverage, speculation, declining credit standards,” he said.

Leaning vs Cleaning

Cracks are starting to appear in the asset-bubble-resistance facade. Questioned about a change in approach at an Oct. 15 speech, Fed chief Ben Bernanke said policy makers would have “to look very hard at that issue and what can be done about it.” He said it was unclear whether monetary policy or regulation and supervision was the proper tool.

Until now, there has been a persuasive argument for a hands- off approach to asset bubbles.

“Is it possible to lean against the upturn, or is it preferable to wait and clean up afterwards?” White said. “The models say you can wait. And it always worked. That’s a pretty powerful argument.”

The counter argument is that models aren’t always reliable. What worked in the past may not work now.

If the recession proves to be longer, deeper and more intractable than recent slumps, central bankers may come to appreciate the merits of leaning versus cleaning. Leaning may entail both “macroprudential instruments,” such as raising reserve requirements, capital requirements and loan-to-value ratios, and a “monetary instrument,” White said.

Prevention as Cure

Cleaning appeared to have worked in the past, following the 1987 stock market crash, the early 1990s recovery from the savings and loan crisis in the U.S., and the late 1990s Asian financial crisis and near-collapse of Long-Term Capital Management. But “it works at the expense of making it worse next time around,” White said.

Cleansing, not cleaning, is what’s really needed. Without it, central banks have to “use a monetary instrument that is ever more aggressive” and will eventually cease to work, he said.

The best medicine, as with most things, may be an ounce of prevention.

“When you see a combination of rapid credit growth, a rapid rise in asset prices across a broad spectrum and changes in spending behavior, it should be a wake-up call that says: We have a problem,” White said.

Central bankers should realize that a lack of action during the credit upswing may impose greater costs to society.

“The facts are so obvious,” White said. “You don’t need to be a rocket scientist. Even an economist, when he sees something happen, will admit it is possible.”

Madoff’s Investors Needed a Blagojevich Moment: Ann Woolner

Dec. 16 (Bloomberg) — Kind to employees, generous to charities, devoted to regulation of the financial services industry, Bernard Madoff was a much-admired man whose oldest, dearest friends are among his biggest victims.

Now it seems those fine attributes cultivated over a lifetime were nothing more than a con, a cover for one of the more blatant ways to steal money without gun or mask.

He told his sons last week he had been running a “giant Ponzi scheme,” precipitating his arrest.

A former chairman of the Nasdaq Stock Market, Madoff was so smooth, so reassuring, so sophisticated, and such a stalwart on Wall Street, that few suspected. If he had been as profane and as blatant about helping himself as Illinois Governor Rod Blagojevich was, the feds would have been on him years ago.

But Madoff’s joyride lasted for decades, judging from the aging red flags now being reported. He made suckers out of some of the most sophisticated investors in the world.

Investment management firms Fairfield Greenwich Advisors, Kingate Management Ltd., Tremont Capital Management and banks in Spain, France and Switzerland are counting up their losses.

In Ponzi schemes, new investors unwittingly supply cash for what passes for dividends to earlier investors, but the securities don’t exist. The operator pockets the rest. And as long as new investors keep showing up and few folks demand their capital back, it all works just fine.

Scam With Longevity

This scam’s longevity helps explain why so many financial sophisticates went for it. Ponzis tend not to last long, and Madoff had been in business since 1960. Their involvement reassured others like them to invest, thus keeping it going.

“Who could ever fathom that an individual who had achieved such a lofty reputation of legitimacy and propriety could ever be capable — in operation or in mentality — of betraying the trust of so many people in so elaborate a manner?” asks Stephen Weiss, a lawyer with Seeger Weiss, who is preparing a lawsuit for Madoff victims.

The question explains how Madoff got away with it. Hardly anyone did fathom it. And those who did, who tried to warn, were waved off.

Like so many Ponzi operators, Madoff seems to have preyed on people much like him. This happens so frequently that it has a name: affinity fraud.

Developing Trust

“A lot of Ponzi schemes involve members of a church or a particular nationality who invest in part because they trust the people who are already investing,” says Carl Loewenson, former federal prosecutor and co-chairman of Morrison & Foerster’s securities litigation and white-collar group. He has no connection to the Madoff matter.

There have been Ponzi schemes targeting Mormons, Orthodox Jews and evangelical Christians. Another targeted Haitian immigrants in Miami.

Madoff’s customers were much like himself, financially sophisticated and wealthy. Many, like him, are Jewish, and a hub of activity was the Palm Beach Country Club, where Madoff had long been a member.

He plied his trade within his social community, his philanthropic network, his professional peers. Many of his victims had been intimate friends for generations.

“When people get investment advice from people who are part of their group, they tend to rely on it,” Loewenson says.

And when they rely on it, so do others in their group. When this group includes the most sophisticated investors around, then why not credit their judgment. Trusting that someone else did the due diligence relieves you of the chore, right?

Great Record

Besides, Madoff produced consistently solid returns that weren’t so outrageous as to look Ponzi-like. “It was not something that sprung up six months ago and paid 60 percent returns,” Loewenson says. “He had a great track record.”

This helps explain the international banks, money managers and institutional investors who flocked to his funds.

OK, but surely somebody, somewhere actually paid attention to where they were sinking millions of dollars. Where was the paperwork? Who was producing it?

When Aksia LLC, a hedge fund investment adviser, noticed that a three-person accounting firm was auditing Madoff’s massive assets, which NASD puts at $17.1 billion, it warned clients to stay away.

And now the auditor, Friehling & Horowitz, finds itself under investigation by a suburban New York district attorney.

It took 70-year-old Madoff’s confession to his sons and employees to finally put an end to all this. His reputation had kept him under the radar and silenced whatever alarms might have otherwise alerted authorities.

With more bravado, he might have been a Blagojevich and the feds would have taken notice. For investors, a crack in the Madoff façade could have saved a lot of heartbreak and many billions of dollars.

Merrill Oil Guru Shifts From Bull to Bear and Back (Update1)

Dec. 16 (Bloomberg) — Francisco Blanch, the Merrill Lynch & Co. analyst who called the $147.27 record crude-oil price almost on the nose, sent markets into a tailspin with his forecast that the next move may be back to $25 a barrel in 2009. Such relief for consumers may be short-lived once the global recession ends, he said.

“If we reignite economic growth to a very fast level, we will have a shortage of energy again,” said the 35-year-old head of global commodity research at Merrill Lynch in London. Oil may rise to $150 in two or three years, said Blanch. World growth will reach 2.2 percent next year and rise to 4.8 percent by 2011, according to the International Monetary Fund.

Blanch changed his 2009 price forecast at least four times this year as the worst global slowdown since 2001 spreads. His most recent estimate that crude may fall to $25 came on Nov. 26. The Organization of Petroleum Exporting Countries’ 13 members meet in Oran, Algeria, tomorrow to try to stem crude’s decline.

“A shift of views from an analyst is a good thing,” said Pierre Andurand, chief investment officer at BlueGold Capital Management LLP, a London-based hedge fund that manages $1.1 billion. “It means he takes the change in economic conditions and the change in balances into account. We can’t say that for many of them.”

On Aug. 7, with crude about $27 below the record set about a month earlier, Blanch said he expected oil demand to be supported by “very healthy” growth in emerging markets.

The following month, Lehman Brothers Holdings Inc. declared bankruptcy, credit markets froze and recessions in the U.S. and the Europe deepened.

Global Recession

Blanch lowered his average 2009 forecast to $90 on Oct. 2 and said crude may fall to $50 in a global recession. Following the announcement, prices dropped 4.6 percent to $93.97 a barrel on the New York Mercantile Exchange.

Two months later, he forecast a fall to $25 if the recession extended to China. Oil tumbled 13 percent to $40.50 a barrel that day and the next.

“What changed our views is that the credit cycle became explosive. Suddenly the cost of money just absolutely ballooned,” said Blanch, who lives in London’s Hampstead area with his wife, Gabriela, a human rights lawyer, and a golden retriever named Guero.

Goldman Sachs Group Inc. analysts Jeffrey Currie and Allison Nathan, and Deutsche Bank AG’s Adam Sieminski, have also reduced price forecasts.

Other Forecasts

London-based Currie and Nathan, in New York, predicted on Dec. 11 that oil would drop to $30 in the first quarter of 2009, half their previous forecast. Washington-based Sieminski predicted an average price of $47.50 for 2009.

Oil for January delivery rose 51 cents, or 1.2 percent, to $45.02 a barrel at 8:34 a.m. on the New York Mercantile Exchange. The price has fallen 51 percent in the past three months.

Born in Madrid, Blanch received a doctorate in economics from the city’s Complutense University and a master’s degree in public administration from Harvard University’s John F. Kennedy School of Government. He was in South Korea to research East Asian economic growth when a financial crisis struck the region, sending oil to $10.35 in December 1998.

At the time, he had “pretty much the same feeling we have now,” Blanch said.

After working as an energy economist for Goldman, Sachs & Co. and consulting for the European Commission, Blanch joined Merrill Lynch in April 2005. He declined to discuss his future after Merrill’s takeover by Bank of America Corp.

Blanch forecast $150 oil in November 2007 when crude was about $96, saying that would set the stage for a global economic slowdown sending the price to $50.

‘Cold Outside’

His $25 prediction may have received more weight than it deserved, said Sarah Emerson, managing director of Energy Security Analysis Inc., a consulting firm in Wakefield, Massachusetts.

“Sure, if the Chinese economy gets really bad, we could go below $25,” she said. “It’s kind of like saying if the temperature drops, it will be cold outside.”

Blanch, who runs half-marathons and takes the subway to work, said the likelihood of $25 oil is less than one in three.

“The best you can do is sort of set out a number of alternatives and try to set out within your central forecast what are the risks around it and what are the alternatives,” he said. “Nobody has a crystal ball.”

U.S. Stocks Rally, Led by Banks, as Fed Cuts Rate to Record Low
Dec. 16 (Bloomberg) — U.S. stocks rallied and the Standard & Poor’s 500 Index climbed to a five-week high after the Federal Reserve cut its benchmark interest rate to a record low and said it will employ “all available tools” to revive the economy.

Citigroup Inc. jumped 11 percent and JPMorgan Chase & Co. climbed 13 percent after the central bank said it “stands ready to expand” purchases of mortgage-backed securities. Goldman Sachs Group Inc. rallied 14 percent after its first quarterly loss as a public company was smaller than some analysts’ estimates. Boeing Co. and Intel Corp. jumped more than 7.2 percent as all 10 industry groups in the S&P 500 increased more than 2.2 percent after the Fed’s announcement.

“A big, widespread, explosive, incendiary shell has come out of the Fed’s cannon,” said Frederic Dickson, who helps oversee about $19 billion as chief market strategist at D.A. Davidson & Co. in Lake Oswego, Oregon. “It’s a bloody big deal. This is the kick-it-up-a-notch moment.”

The S&P 500 added 5.1 percent to 913.16. The advance put the benchmark index above its average level during the past 50 days for the first time since September. The Dow Jones Industrial Average gained 359.61 points, or 4.2 percent, to 8,924.14. The Russell 2000 Index of small companies increased 6.7 percent.

The Fed cut its target rate for overnight loans between banks to a range of zero to 0.25 percent. The Fed’s decision came after simultaneous recessions in the U.S., Europe and Japan dragged the S&P 500 down almost 45 percent from its 2007 record and sent benchmark indexes from Brazil to Bangkok into bear markets.

Banks Rally

Citigroup climbed 83 cents to $8.23, while JPMorgan jumped $3.72 to $32.35. The S&P 500 Financials Index jumped 11 percent, the steepest gain among 10 industries and the group’s steepest advance since Nov. 24.

The Fed said in its statement that the recession is likely to warrant exceptionally low levels of the federal funds rate “for some time.” The statement noted that the Fed has already announced it will purchase agency debt and mortgage-backed securities, and said the central bank is ready to expand the program. Policy makers continue to weigh the potential benefits of buying longer-term Treasury securities, the statement said.

“They’re trying to rekindle the confidence of consumers and businesses, and that ultimately drives profits in the stock market,” said Bruce McCain, chief investment strategist at Key Private Bank in Cleveland, Ohio, which manages $30 billion.

Treasury notes rallied, sending yields to record lows, on expectations the Fed will buy the securities to force borrowing costs lower. The dollar weakened to $1.40 against the euro for the first time in two months.

Goldman’s Loss

Goldman Sachs added $9.54, the most since Nov. 24, to $76. Its loss of $4.97 a share in the three months ended Nov. 28 was the company’s first quarterly deficit since going public in 1999 as asset values and investment-banking fees declined. The average estimate of 18 analysts surveyed by Bloomberg was for a loss of $3.73, with UBS AG’s Glenn Schorr estimating a loss of as much as $5.50 a share.

Compensation and benefits, the firm’s biggest expense, fell to a negative $490 million in the quarter, as the company cut 2,500 jobs and lowered average pay per employee 45 percent to $363,654. The company that set a Wall Street profit record in 2007 converted to a bank-holding company and accepted $10 billion from the U.S. government earlier this year as investors lost confidence in companies that rely on debt-market funding.

Morgan Stanley, the Goldman Sachs competitor that also became a bank, rallied 18 percent to $16.13. The firm will report fourth-quarter results tomorrow. Analysts estimate a loss of 34 cents a share, excluding some items, according to a Bloomberg survey.

Fed Cuts Rate to as Low as Zero, Will Use All Tools (Update2)

Dec. 16 (Bloomberg) — The Federal Reserve cut the main U.S. interest rate to as low as zero and said it will buy debt as the next step in combating the longest recession in a quarter-century and reviving 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 failed to reverse the economic downturn. Today, the Fed said it will target a federal funds rate of between zero and 0.25 percent.

“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 dollar tumbled against the euro and yen. Stocks climbed, pushing the Dow Jones Industrial Average up 216 points, or 2.6 percent, to 8797.12 at 2:53 p.m.

Printing Money

“The Fed is sending a message that it will print money to an unlimited extent until it starts to see the economy expanding,” William Poole, former president of the St. Louis Fed and now a senior fellow at the Cato Institute in Washington, said in an interview with Bloomberg Television. Poole is also a contributor to Bloomberg News.

The statement noted that the Fed has already announced it will purchase the debt issued or backed by government-chartered housing finance companies, 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.

The deepening economic slump pushed unemployment to 6.7 percent last month, the highest level since 1993, while builders broke ground on the fewest new homes since record-keeping began in 1947. Deflation is also emerging as a risk: consumer prices fell the most on record in November, the Labor Department said earlier today.

No Dissent

Today’s vote was unanimous. In a related move, the Fed lowered the rate on direct loans to banks and securities dealers to 0.5 percent. It set the payment on the reserves that commercial banks hold at the Fed at 0.25 percent, down from 1 percent.

Fed policy makers twice pared the federal funds rate, or overnight lending rate, to 1 percent since adopting it as the main tool of monetary policy in the late 1980s. The 1 percent rate held from June 2003 to June 2004, and again from the end of October to today.

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 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.

Emergency Loans

Bernanke, acting with New York Fed President Timothy Geithner, has set up emergency loan programs aimed at averting a collapse of the nation’s credit markets. Geithner is President- elect Barack Obama’s pick for Treasury secretary and didn’t attend today’s meeting.

The Fed has enlarged bank reserves, supported issuance of commercial paper and provided liquidity to government bond dealers. It is also swapping dollars with the European Central Bank and its other counterparts to supply banks in other countries.

The moves have swelled the Fed’s balance sheet to $2.26 trillion from $868 billion in July 2007. That’s in addition to the $700 billion Troubled Asset Relief Program, which the U.S. Treasury has used since October to channel about $335 billion of capital injections into banks and other financial companies.

Still, the economy has crumbled, with employers cutting 533,000 jobs from payrolls in November for a total loss this year of 1.9 million, which more than erases the 2007 gain of 1.1 million.

Credit remains scarce in many markets and major financial institutions worldwide continue to report losses and writedowns totaling $994 billion.

Shrinking Economy

Macroeconomic Advisers LLC, a St. Louis-based consultant, says the economy is probably shrinking at a 6.5 percent annual pace this quarter, which would be the biggest drop since 1980.

The firm forecasts a 4.2 percent annual contraction rate in the first quarter, returning to no growth in the second quarter and a 2.3 percent expansion rate in the second half of 2009.

Early this month, as a panel of leading U.S. economists declared the recession began in December 2007, Bernanke signaled he was ready to dig deeper into the central bank’s toolkit. He said he may use less conventional policies, such as buying Treasury securities, because his room to lower the main U.S. rate from the current 1 percent level was “obviously limited.”

Fading Relevance

The federal funds target rate has weakened as a monetary policy tool because the Fed’s flood of funds has caused the average daily rate to trade below the policy goal every day since Oct. 10.

The gap between the target and the effective rate, or average daily market rate, has averaged about a half point since Sept. 12. The gap averaged just above zero from the start of this year through Sept. 2.

The central bank is trying to lower mortgage rates by purchasing up to $100 billion of debt issued by housing-finance providers Fannie Mae and Freddie Mac and $500 billion of mortgage-backed securities guaranteed by the companies.

The Fed’s counterparts around the world have staged their own interest-rate cuts. The ECB has lowered its main rate to 2.5 percent this month from 4.25 percent in July, while the Bank of England reduced its rate to 2 percent this month from 5.75 percent in July.

ECB President Jean-Claude Trichet said yesterday there’s a limit to how far the bank can cut interest rates and signaled policy makers may pause in January. “Do we have a feeling there is a limit to the decrease in rates? At this stage certainly yes,” Trichet told journalists in Frankfurt.

While the Fed can’t push interest rates below zero, “the second arrow in the Federal Reserve’s quiver — the provision of liquidity — remains effective,” Bernanke said in a Dec. 1 speech.

US interest rate slashed to 0.25%

US Federal Reserve chairman Ben Bernanke

The US Federal Reserve has slashed its key interest rate from 1% to 0.25% as it battles the country’s recession.

The central bank’s key rate, the target rate for overnight federal funds, is at its lowest since records began in 1954.

The rate has been cut drastically by the Federal Reserve from the 5.25% where it stood in September 2007.

Earlier in the day, official data confirmed that the threat of inflation is receding, as consumer prices fell a record 1.7% in November.

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