Page last updated at 11:39 GMT, Wednesday, 17 December 2008

Q&A: US rate cut

Graph of US interest rates
The Federal Reserve has slashed its key interest rate to between zero and 0.25% - but what will the impact of this for the US economy?

What do zero interest rates mean?

It doesn't mean that home owners or businesses will be able to get loans from High Street banks for free. What it does mean is that commercial banks themselves will be able to borrow -for limited periods of time - without paying interest.

Why are rates between 0.25% and zero - and not simply zero?

The key rate is now virtually zero and economists say that for most practical purposes it does not make a huge difference. What central banks and policymakers plan to do next is more important for the economy.

Can rates ever fall below zero?

Yes. As markets have slumped in recent weeks, and with economic prospects gloomy, investors have been looking for safe havens for their money. The safest are government securities or bonds. With such securities, the interest they paid falls as demand pushes up the price.

At certain points recently, demand has been so strong that the return on short-term US Treasury bonds has become negative.

In effect, investors were so pessimistic about prospects for the rest of the market, that they were prepared to lose a little money - to ensure the rest of their investment was protected.

What else can the Fed now do?

The Fed has been pretty clear that this is not the end of its efforts to kick-start the US economy and get money flowing again.

It has said it will use "all available" tools in bringing down the real costs of borrowing that homeowners and small businesses are currently experiencing.

The Fed is doing this by buying up US government debt and also buying up loans to companies and householders - which has the effect of forcing down yields or interest rates on these products.

The Fed could take steps such as buying up securities issued by the two US mortgage giants Freddie Mac and Fannie Mae - which would help to free-up the housing market - and it has said it is ready to do this.

The bank has also signalled that rates are likely to be near zero for "some time". Over the longer term this should help to drive down borrowing costs and support stock markets.

The strategy of the Fed in buying government bonds is similar to the "quantitative easing" Japan carried out when it was fighting deflation.

How does 'quantitative easing' work?

This is where a central bank buys up securities such as government securities in the open market. It works in two ways.

First, it pushes the prices of these government securities higher - and the interest rates on these fall as demand sends their prices higher. Lower interest rates for government securities should help in lowering rates - cutting borrowing costs - in the wider market.

Second, as this effectively means more money from the central bank is sloshing around the system, High Street banks should find they have more cash in reserve. At some point - hopefully - they will start lending it out again.

However, there is a downside to this, in that this policy of effectively pumping money into the system can stoke up inflation further down the line.

So will the Fed's policies work?

This is the lowest the US central bank's key rate has been since records began in 1954.

However, it will take time for the effect of these cuts to feed through into the wider economy, so it will be some time before we are certain they have worked.

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