The Fed’s rate at zero? It’s no longer a far-fetched idea

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Just a day after the Federal Reserve dropped its key short-term interest rate to 1% -- matching the generational low reached in 2003-04 -- the betting is intensifying on another cut.

Trading in futures contracts on the federal funds rate, the Fed’s benchmark, implies a 51.4% probability that the central bank will slash the rate to 0.50% on or before its next meeting on Dec. 16, according to Bloomberg News data.

On Wednesday, the probability of a cut to 0.50% was 32%.

At a minimum, the futures market expects the Fed to take its rate down to 0.75% on Dec. 16.

Rate expectations may be cueing off the government’s report today that the economy shrank at an annualized rate of 0.3% in the third quarter. Although analysts figured the economy had contracted in the period, the details were ugly -- particularly the 3.1% decline in real consumer spending, the biggest drop since the vicious recession that began in 1980.

There are psychological reasons why the Fed would prefer not to cut its rate below 1%. The closer the Fed gets to zero, the more likely that investors will worry the U.S. economy is facing a long period of misery on par with what Japan faced after its real estate markets crashed in the early 1990s.

The Bank of Japan had to maintain its benchmark interest rate at or near zero for most of the 1999-2006 period, before policymakers finally felt comfortable that the economy was in a sustainable recovery.

The wording of the Fed’s statement on Wednesday suggested that ‘they may [cut] again if necessary, but are probably hoping that they will not have to take the zero-option on rates,’ said Christopher Rupkey, economist at Bank of Tokyo-Mitsubishi in New York.

Others see more cuts as inevitable. ‘I think the Fed is going lower,’ said Tom Higgins, chief economist at investment firm Payden & Rygel in L.A. ‘Zero is the floor.’

Given the severity of the credit crunch and what that has wrought in the economy, he said, the Fed’s attitude can only be, ‘Why not throw everything at it?’