Still Fighting the Good Fight

Story Highlights:

• US markets rose today as the Fed announced it would cut rates to a range of 0%-0.25%.
• As the fed funds rate approaches zero, many worry the Fed is running out of ammo.
• But don't fret—the Fed has many more tools at its disposal, including balance sheet expansion, discount window lending, and lowering reserve requirements.

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Tuesday was a good day for US stocks, as Financials led the S&P 500 to end up 5.1%. Most notably, the Fed announced how it would continue to fight the good fight—a combination of low rates and the innovative provision of liquidity.

The most recent action in the Fed's long rate cutting campaign saw fed funds reduced to a range of 0%-0.25%. The move was more than the widely expected 0.50% cut, and the Fed said it would hold rates "exceptionally low" for some time. Yet as the target rate approaches zero, one prominent worry remains the Fed may be running out of ammo.

However, those fears are likely overblown, as the Fed still has a very deep bench. In a speech earlier this month, Fed Chair Ben Bernanke outlined the Fed's future policy options. As rates draw closer to zero, he said the Fed would favor further expansion of its balance sheet in the process known as quantitative easing. Tuesday's announcement confirmed the Fed still favors that course.

Beyond the more conventional measures of purchasing short-term Treasuries, agency debt, and mortgage-backed securities, officials have said they may also buy longer-duration Treasuries to bring down long-term rates. Because the Fed typically works on the short end of the yield curve and leaves the long end to market forces, buying longer-duration securities would be a bold move. It would expand rate manipulation further than it's ever been and could at least partially distort normal market forces in the near term. So far the Fed's shown a willingness to take risks and innovate—a good thing in the face of a full-blown panic. Also, remember the Fed has more traditional methods along with the new measures it's considering—it has yet to reduce reserve requirements. It could also drop the discount rate, lowered today to 0.5%, further.

So, despite fears to the contrary, the Fed isn't out of tools—it can pick and choose between new innovations and more conventional methods as it labors to restart credit markets. While we've seen some bumbling and are likely to see some more, the Fed is far from out of options. And though it'd be better if we minimized additional bumbling and ensuing uncertainty; we think that's a relatively small cost to pay for healthier credit markets down the line.