America yesterday led the western financial system into a brave new world, a world of zero interest rates and “quantitative easing”. The initial stock market reaction to the Federal Reserve rate cut was euphoric with share prices surging more than 4 per cent within an hour of the announcement.

Yet the move is unnerving in many ways. For a start, it leaves the Fed with no ammo left, at least in terms of interest rates.

Ultra low interest rates cause real problems for savers and technical problems for markets. We have already had the bizarre sight of interest rates briefly going negative on some Treasury bonds, as investors paid the Government to take their money. The Fed’s move underlines the seriousness with which it views the economic outlook.

As the Fed said in its statement, consumer spending, business investment, industrial production and unemployment have all worsened over the past month. The prospects are so bad that it expects to keep interest rates at these exceptionally low levels “for some time”.

While near zero interest rates are a new phenomenon in the west, they were in place for years in Japan, without dragging the economy out of its decade long slump. But the Fed also promised a range of what economists call quantitative easing measures and what ordinary mortals call flooding the markets with cash.

It said it was ready to step up its purchases of debt from the huge government-backed mortgage finance companies and that it was evaluating the potential benefits of buying longer-term Treasury securities.

The aim is to bring down mortgage rates and other commercial interest rates in an effort to revive the flagging economy. In response, the yield on the 30-year Treasury bond fell to an all-time low of less than 2.89 per cent.

The bigger-than-expected cut in the Fed’s target rate also reversed some of the dollar’s recent strength.

The Fed moves will increase pressure on the Bank of England to take more aggressive action after this month’s cut in rates to 2 per cent. Many economists believe the Bank should cut rates below 1 per cent next year and take other steps to pump liquidity into the system.

For investors, falling rates and the recovery in equities make bonds look more attractive still. Corporate bonds are now pricing in a level of defaults as bad as seen in the Great Depression. Yet the concerted action by authorities around the world make that seem most unlikely. Whether equities are also cheap is another matter.

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