With the country spiraling deeper into recession, the Federal Reserve is ready to slash its key interest rate -- perhaps to an all-time low-- in hopes of cushioning some of the economic fallout felt by many struggling Americans.

To battle the worst financial crisis since the 1930s, Fed Chairman Ben Bernanke and his colleagues already have ratcheted down their main lever for influencing the economy -- the federal funds rate -- to 1 percent, a level seen only once before in the last half-century.

The Fed opens a two-day meeting Monday to assess to economy and decide its next move on rates. Another reduction to the funds rate, the interest banks charge each other on overnight loans, is all but certain to be announced Tuesday.

Many economists predict the Fed will cut its rate in half -- to just 0.50 percent. A few think the Fed could opt for an even more forceful action -- lowering rates by a whopping three-quarters percentage point or more. If that larger cut occurs, it would be the lowest on records that track the monthly average of the targeted funds rate going back to 1954.

Even an aggressive rate reduction won't turn the economy around, analysts said.

"It is not so much going to give the economy a big push forward. It's more a case of trying to help the economy from being pushed further backward by all these negative events," said Stuart Hoffman, chief economist at PNC Financial Services Group.

However deeply the Fed decides to cut rates, the prime rate -- now at 4 percent -- for many consumer and small-business loans would drop by a corresponding amount. The prime lending rate is used to peg rates on home equity loans, certain credit cards and other consumer loans. Cheaper rates could give pinched borrowers a dose of relief.

The goal of lower borrowing costs is to entice people and businesses to spend more, which would revive the flat-lined economy. So far, though, the Fed's aggressive rate reductions have failed to lift the country out of a recession that started last December.

Clobbered by the financial crisis, worried banks have hoarded their cash and been extremely reluctant to lend money to customers. Fearful consumers, watching jobs vanish and their investments tank, have sharply cut back their spending, including big-ticket purchases like homes and cars that typically involve financing.

The negative forces have fed off each other, creating a vicious cycle that Bernanke and Treasury Secretary Henry Paulson have been desperately trying to break.

To unlock lending and get financial markets to operate more normally, the U.S. has resorted to a string of radical actions, including a $700 billion financial bailout where the government is making cash injections in banks in return for partial ownership stakes.

In terms of rate cuts, the Fed is getting ever closer to running out of ammunition.

It can lower the funds rate only so far -- to zero. Even if that were to happen -- a point of debate among economists -- the prime rate would fall to 3 percent but no lower.

Against that backdrop, Bernanke says the central bank is exploring other ways to stimulate the economy.

The Fed could buy longer-term Treasury or agency securities on the open market in substantial quantities, Bernanke says. This might lower rates on these securities and help spur buying appetites.

Another option the Fed has mulled: issuing its own debt, which would give the central bank cash and more flexibility to battle the financial crisis. To do that, however, the Fed would need new powers from Congress.

"The Fed wants to show that it has tools and options and is not out of tricks because interest rates are very low," said Michael Feroli, economist at JPMorgan Economics. "The problems holding back the economy are fairly long lived in nature."

To combat the financial crisis, the Fed already has created first-of-its-kind programs, such as getting cash directly to companies by buying up mounds of "commercial paper," the short-term debt firms use to pay everyday expenses such as payroll and supplies.

It also recently launched massive programs to boost the availability of consumer credit, including that for cars, student loans, homes and credit cards. The Fed also is making loans to banks, is providing a financial backstop to the mutual fund industry, and has injected billions of dollars in financial markets here and abroad.

The Fed could opt to expand programs by enlarging loans it's now making, providing loans to other types of companies, or buying more and different types of debt. The Fed's balance sheet has ballooned to $2.2 trillion, from close to $900 billion in September, reflecting some of those other activities to get credit flowing again.

Even with all the bold moves, the economy continues to sink deeper into despair.

Skittish employers axed 533,000 jobs in November alone. That drove the unemployment rate up to 6.7 percent, a 15-year high.

Since the start of the recession, the economy has shed nearly 2 million jobs. Analysts predict another 3 million more will be lost between now and the spring of 2010.

Last week alone, Bank of America Corp., tool maker Stanley Works and Sara Lee Corp., known for food brands such as Jimmy Dean and Hillshire Farm, announced job cuts.

General Motors Corp., Chrysler LLC and Ford Motor Co., meanwhile, are fighting for their survival. GM and Chrysler have said they're in danger of running out of money within weeks. The White House is exploring new ways to help Detroit after rescue efforts collapsed in Congress.

With the employment market eroding and consumers retrenching, the economy could stagger backward at a shocking 6 percent rate in the current October-December quarter, analysts predict. It shrank at a 0.5 percent pace in the third quarter.

President-elect Barack Obama is advocating an economic recovery plan that includes spending on big public works projects to bolster jobs. His plan also includes tax cuts to spur consumers to spend more and businesses to step up investment and hiring.

Americans are sorely feeling the toll of the housing, credit and financial crises.

Households' net worth fell 4.7 percent in the third quarter to $56.5 trillion as people watched the value of their homes and investments tank. It marked the fourth straight quarterly decline, the Fed said.

Don't expect Wall Street's turmoil to ebb in the year's last full week of trading as investors face questions about an auto bailout, the banking crisis, and the Federal Reserve's final rate-setting meeting of 2008.

The market, still hovering at decade lows, has yet to show any sign of a traditional year-end rally. And the next few days it will face a number of tests that could determine if investors are able to get past all the negative economic news to end the year on a bright note.

The fate of Detroit's three biggest automakers continues to be in question this week after the Senate failed to pass a $14 billion bailout for the Chrysler LLC and General Motors Corp. Ford Motor Co. has said in the past that it does not need government money to survive.

The White House this week is expected to unveil ways to provide emergency aid to the automakers, which have said they could run out of cash within weeks without government help. Many expect that the Bush administration will use money from the $700 billion financial bailout fund to provide loans to the carmakers.

"If the administration had some notion that this was a house of cards, that this was going to bring the entire economy down, then they have the authority to write checks out of the already passed bailout program," said Jack Ablin, chief investment officer at Harris Private Bank in Chicago.

On Sunday evening, major stock indexes were modestly higher in futures trading. Dow Jones industrial average futures rose 49 points, or 0.56 percent, to 8,738. Standard & Poor's 500 index futures added 5.00, or 0.56 percent, to 891.00; while Nasdaq-100 futures rose 7.25, or 0.60 percent, to 1,220.75.

That might add to Wall Street's resilient performance on Friday after it rebounded from an early sell-off to end higher after the government said it would assist troubled U.S. automakers. The Dow rose 0.75 percent, and ended the week with a loss of just 0.07 percent.

The S&P 500 rose 0.42 percent last week, while the Nasdaq advanced 2.08 percent. For the year, the Dow is down 34.9 percent, the S&P 500 is down 40.1 percent and the Nasdaq is off 41.9 percent.

"The market's been pretty resilient," said Matt King, chief investment officer of Bell Investment Advisors. "The bad news keeps coming out ... but the market's been holding firm and making some good gains. So to us that's a good sign."

Along with uncertainty about the auto sector, the Fed's policy meeting on Monday and Tuesday will also remain in focus. The central bank is expected to lower its benchmark fed funds rate by a half-percentage point to 0.5 percent.

But, with rates so low, that means the Fed will soon run out of room to lower interest rates further to stimulate the economy.

Goldman Sachs Group Inc. and Morgan Stanley, the two biggest U.S. investment banks, will report results this week.

Analysts expect Goldman on Tuesday will report its first loss since becoming a public company in 1999. Morgan Stanley is also expected to report a loss during the fourth quarter.

Investors will also pore over economic reports, including Tuesday's release of the government's Consumer Price Index for November and housing starts.

While all eyes are on Treasury Secretary Henry Paulson and his $700 billion bailout plan, Federal Reserve Chairman Ben Bernanke is conducting his own economic recovery program—and his is measured in trillions, not billions. What's more, unlike Paulson, Bernanke doesn't have to check with Congress before shoveling out the money. On Nov. 25 the Federal Reserve announced another buying-and-lending program that will probably boost the central bank's assets (such as loans to financial institutions) to around $3 trillion. That's triple the level in mid-September, when the Fed began its expansionary campaign.

The Fed is trying to kill two birds with one very large stone, namely a drastic expansion of its balance sheet. One of its twin objectives is to get more money circulating in the economy. The other is to prop up weak financial institutions to avoid a cascade of failures. If the Fed succeeds it will appear both brilliant and efficient. The risk is that by trying to accomplish too much, the central bank will fall short of one or both of its objectives.

It's easy to get lost in the blizzard of details. Since the credit crisis began in August 2007, the Federal Reserve has taken 51 measures to fix the financial system, not including its conventional tool of cutting the federal funds rate, according to a count by UBS (UBS).

But the big picture is simple. The credit crunch is so severe that the Fed has been forced to go beyond its peacetime role of guiding the economy by steering short-term interest rates. With banks weakened and afraid to lend, it is making or guaranteeing loans to particular institutions and in some cases outright buying assets. On Nov. 25 the Fed waded deeper than ever into a kind of monetary industrial policy. It announced it would directly buy $500 billion worth of mortgage-backed securities backed by Fannie Mae (FNM), Freddie Mac (FRE), and Ginnie Mae, as well as $100 billion of the corporate debt of Fannie, Freddie, and the Federal Home Loan Banks.

Warnings of Risk

Meanwhile, the Federal Reserve Bank of New York will lend up to $200 billion to holders of highly rated securities backed by auto, student, and small business loans and credit-card receivables. All of those loans and purchases will show up as assets of the Federal Reserve System, which have already shot up to about $2.2 trillion from $1 trillion in September.

What could go wrong? Fed watcher James D. Hamilton, an economist at the University of California at San Diego, warns that the Fed is buying, or accepting as loan collateral, assets that no one else wants. The danger of this approach, he says, will become clear when the economy starts to strengthen. At that point the Fed will need to drain away lots of excess money in the financial system. Ordinarily it does that by selling securities on its balance sheet and calling in loans. But it won't be able to do that if the assets are so toxic that no one wants them or dumping them would destabilize weak institutions. "It's tricker because the Fed has exposed itself to risks," says Hamilton.

But Columbia University economist Frederic Mishkin, who stepped down as a Fed governor in August, says Fannie and Freddie debt should be easy to sell, while the loans to holders of asset-backed securities are temporary by design. Plus, says Mishkin, the Fed has to act boldly: "This shock is in many ways more complex and harder to deal with than the financial shock that occurred during the Great Depression."

Coy is BusinessWeek's Economics editor.

The Federal Reserve said today it is establishing a special fund to lend money directly to businesses so they have adequate cash to operate, a major move by the central bank to ensure that "main street" companies are not crippled by the financial crisis gripping Wall Street and other money centers around the world.

Under the new program, the Fed will buy up commercial paper, the short-term debt that large companies across the country use to fund their day-to-day operations. That puts the Fed in the unprecedented position of, in effect, funding individual companies by buying their debt.

The "Commercial Paper Funding Facility" will be a special entity, funded by both the Fed and the Treasury Department, that will purchase three-month notes issued by corporations. It will include debt backed by specific assets, but also will make unsecured loans. Entities that sell unsecured debt to the new entity will have to pay a fee to account for the higher risk.

After a day of sharp losses, Wall Street market futures turned higher on hopes that the Fed announcement will help ease a credit crisis in which banks and financial firms have become hesitant to lend, and companies have worried about raising the money needed to pay their bills.

Problems in the commercial paper market have been one of the most direct ways in which the financial crisis has threatened to affect the nuts and bolts economy.

With financial markets in near-meltdown, governments around the world have been scrambling to find new ways to infuse vast amounts of cash into banks and even directly to companies to help resuscitate the global financial system.

The Fed yesterday said it would push $900 billion into the U.S. banking system, a six-fold increase in its program of lending money to banks.

The measures followed similar efforts by other central banks and governments around the world over the weekend and yesterday to get financial institutions to stop hoarding money and start lending to one another and to their customers.

It wasn't enough. Stock markets began a steep tumble in Asia, where most national markets were down considerably, and then declines accelerated in Europe on fears of new bank failures. The French stock index tumbled 9 percent, the German index dropped 7 percent and the British benchmark index fell nearly 8 percent. Russia was off nearly 20 percent.

In the United States, the Dow Jones industrial average fell 3.6 percent, closing below the 10,000 level for the first time since 2004. It had been down nearly twice that at one point before staging a late rally.

With the financial crisis now engulfing most of the developed world, a meeting scheduled for later this week in Washington of the International Monetary Fund and World Bank will probably turn into a summit that could provide a forum for coordinated action.

But there was little sign of coordination among European leaders, who could not agree over the weekend on a common approach to the crisis and who yesterday bickered over what sorts of protections they would offer investors and institutions.

The Federal Reserve has requested that the Treasury Department deposit $40 billion with the central bank in an effort to help the Fed continue to stabilize the financial markets and address concerns about whether it is overstretched.

  Washington Post Staff Writers
Tuesday, September 16, 2008; 8:25 PM