Fed cuts at end of road?
The Federal Reserve on Wednesday cut its benchmark interest rate for the second time in as many months but signaled that the reduction would be the last one for a while.
The central bank reduced the rate by a quarter of a point to 4.5% in an effort to protect the economy against the effects of high oil prices, falling home prices and a squeeze on credit caused by the sub-prime mortgage meltdown.
The stock market, which rose early in the day in anticipation of the rate cut and fell immediately after it, continued to rally as investors were apparently heartened by the Fed’s suggestion that Wednesday’s action, coupled with a cut last month, would be sufficient to keep the economy from falling into recession.
The Dow Jones industrial average jumped 1% to 13,930.01. The Standard & Poor’s 500 index gained 1.2%, and the Nasdaq composite index surged 1.5%.
For most of this year, the Fed held interest rates steady, concerned that lowering them could make money so cheap that it would spur inflation, especially at a time of surging energy prices. But after worries about housing and credit grew in late summer, the central bank slashed its key rate by half of a point Sept. 18.
Wednesday’s more modest cut, and the hint that more are unlikely, suggests that the Fed remains more concerned in the long term about inflation than about recession. Rising oil prices are a particular concern. The price of oil shot up again Wednesday, reaching a record.
Rising transportation costs are expected to gradually force up prices of consumer goods, and high heating costs in the winter could shock residents of the country’s colder climates.
“Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation,” the Fed said in a statement about its rate decision.
Earlier in the day, the Commerce Department reported that the economy grew at a stronger-than-expected 3.9% annual rate in the third quarter, the fastest pace in 18 months. Strong exports and consumer spending helped offset a plunge in investment by builders in home construction.
The third-quarter growth figures “show continued resilience in a two-track economy, with housing declining dramatically but the rest of the economy actually accelerating,” said Nigel Gault, an economist at Global Insight, a forecasting firm in Lexington, Mass.
In its statement, however, the Fed, echoing the forecasts of Gault and many other economists, said growth was likely to slow, “partly reflecting the intensification of the housing correction.” But the central bank said its rate cuts in September and Wednesday “should help forestall some of the adverse effects . . . from the disruptions in financial markets and promote moderate growth over time.”
John Lonski, chief economist at Moody’s Investor Services, said the Fed’s concern with inflation and the confident tone of its statement were out of step with the views of investors and businesses. “I thought the Fed would show greater sense to the economic dangers of unfinished home price deflation,” Lonski said.
“It was surprising that the Fed effectively lowered economic risks relative to inflation risks. Many in the business world and the financial marketplace are not of the same opinion as the Fed. Many still believe the risks of recession well exceed the risk of a rise in core inflation.”
Gault at Global Insight predicted the economy would grow at only a 1.5% annual rate in the fourth quarter, and no faster than that in the first half of 2008.
“The question now is how well [the economy] can withstand even steeper declines in residential construction, the general tightening in credit conditions, falling house prices, oil prices at around $90 per barrel and their negative implications for consumer and business spending,” Gault said. “We expect the damage to come through soon.”
At the White House, Bush administration officials argued that the third-quarter growth data suggested the economy was more resilient than jittery markets had suggested. “The housing market is clearly the weak sector of the economy right now and has been for the past year and a half,” Edward Lazear, chairman of President Bush’s Council of Economic Advisors, said at a White House news conference.
“Despite that, housing does not seem to be leaking into other parts of the economy.”
Wednesday’s Fed action was unusual in that it was not unanimous. Nine committee members voted for the rate cut, while one member, Thomas M. Hoenig, president of the Federal Reserve Bank in Kansas City, voted against it, saying he preferred no change in the fed funds rate, at which banks make overnight loans to other banks.
In conjunction with the reduction in the funds rate, the Fed’s Board of Governors unanimously approved a quarter of a point decrease in the central bank’s discount rate to 5%. The discount rate is paid by banks when borrowing directly from the central bank.
