Can Interest Rates Go Much Lower?

The Federal Reserve cuts again, but the central bank may be about done.

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Wall Street gave up some of its steep gains Tuesday while investors digested the Federal Reserve's decision to cut interest rates by three-quarters of a percentage point.

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The Federal Reserve broke out its two-handed butcher's knife Tuesday and cut the federal funds rate by a hefty three-quarters of a percentage point, continuing its aggressive campaign to jump-start the sputtering U.S. economy and defrost credit markets. Although the stock market initially shuddered at the announcement—some investors had expected a full-percentage-point cut—the Dow eventually pushed higher, ending the day up some 420 points, or 3.5 percent. (Investors were also heartened by better-than-expected earnings news from Lehman Brothers and Goldman Sachs.) But with Ben Bernanke and the rest of the Fed's policymaking committee already having slashed the federal funds rate to 2.25 percent, from 5.25 percent in September, investors are now wondering how much lower short-term interest rates can go?

Here are three reasons why the Fed's rate-cutting campaign may be winding down:

Enough juice in the tank: With 225 basis points remaining, Bernanke obviously has room to lower rates further. But former Fed vice chair Alan Blinder, now a professor at Princeton, says that today's three-quarter-point cut was likely the central bank's last big move. "I think we may be near the end," Blinder says. He argues that with the previous cuts and the recent measures injecting liquidity directly into the market—coupled with the economic stimulus package—"the Fed has already put a lot of easing into the pipeline." And while the housing sector and financial markets remain under serious strain, the economy as a whole "is not collapsing around us." Still, Blinder thinks additional, small-scale cuts to the federal funds rate are possible.

Inflationary angst: In its statement accompanying the action, the Fed indicated that while the economic outlook has deteriorated, inflationary concerns have mounted. "Inflation has been elevated, and some indicators of inflation expectations have risen," the central bank said. But even though it expects such forces to ease in coming months, the Fed's attention to pricing pressures could indicate that it will refrain from further aggressive rate cuts to keep inflation at bay. "I don't think they would [address inflation in the statement] unless they could see a bottom," says Vincent Reinhart, a former Fed economist and now a scholar at the American Enterprise Institute.

It's the confidence, stupid: Jerry Webman, a senior investment officer and chief economist for OppenheimerFunds, says that the Fed has now brought interest rates down to a level that should be sufficient to produce its desired economic jolt (although it will still take several months for the cuts to kick in). But Webman also argues that the problems in today's economy are rooted largely in the credit markets, as banks—concerned about borrowers' ability to repay loans—have been choking off funding to businesses and consumers alike. "It doesn't matter what the interest rates are if you can't get money," Webman says. To that end, Webman expects the Fed to rely more on its recently launched liquidity initiatives rather than old-fashioned rate cuts going forward.