Fed slashes key rate to stir lenders
The Federal Reserve slashed its key interest rate Tuesday, moving to deliver shock therapy to financial markets nervous about sub-prime mortgages and a stubborn credit crisis.
The half-point cut in the benchmark short-term rate was steeper than most analysts had expected. And Wall Street, which had worried increasingly in recent weeks that the housing and credit problems could put the economy into recession, rallied on the news. The Dow Jones industrial average soared more than 330 points, or 2.5%, its sharpest one-day point gain in more than four years.
“It was everything the market had been begging for for weeks -- and more,” said Richard A. Weiss, chief investment officer at City National Bank in Los Angeles.
But the Fed’s aggressive action risks fueling inflation. Implicitly acknowledging that risk, the central bank expressed concern about prices for the first time in weeks and signaled that it did not plan a series of rate reductions, which some analysts have predicted.
The contrary combination of a larger-than-expected cut and the signal that the Fed has little interest in making further rate reductions captured the hard-to-read nature of the economy’s current condition.
On the one hand, the housing market has been roiled by surging defaults on sub-prime mortgages, which go to borrowers with less-than-perfect credit histories. The defaults rippled through financial markets, which until this summer had favored mortgage-backed securities, convincing many investors that the financial products were nowhere near as secure as they’d previously thought and causing many to stop buying them.
On the other hand, aside from the housing and financial sectors, the economy has continued to show moderate strength and low inflation.
And, in a sign of how an action that buoys one group of economic participants can be bad news for others, the rate cut sent the dollar tumbling to a record low against the euro, and an index showing the value of the dollar compared with six other currencies fell to its lowest level in 15 years.
The rate cut was cold comfort to the foreign investors whose purchases of U.S. securities have been crucial to financing the nation’s debt-heavy economy. That’s because the dollar’s decline automatically reduced the value of those securities in the investors’ home currencies.
Most analysts had expected no more than a quarter-point rate decrease. Some interpreted the larger cut as a sign that the central bank believed the economy faced deeper problems than was generally thought. And there were predictions that Tuesday’s cut would be followed by further reductions in the months ahead.
Fed officials, however, said that their steep cuts had a very specific purpose: to get lenders to stop worrying so much about a credit freeze-up and to begin lending again. They said a failure of lenders to do so could worsen the housing downturn and slow the economy’s already modest growth.
Tight credit conditions have “the potential to intensify the housing correction and to restrain economic growth more generally,” the Fed’s rate-setting committee said in a statement that accompanied the cuts. “Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets.”
To underscore their reluctance to make further cuts, the policymakers resurrected a subject that they had made almost no mention of recently -- inflation.
“Readings on core inflation have improved modestly this year,” the central bankers said in their statement. “However, the committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.”
Diane Swonk, economist with Mesirow Financial in Chicago, said, “This is some real action here, and they don’t intend to come back with more cuts.”
The Fed dropped to 4.75% the key federal funds rate, which banks pay on overnight loans to one another. It also cut the less-significant discount rate on Fed loans to banks by half a percentage point as well, to 5.25%.
Major banks quickly followed the Fed’s lead, cutting the so-called prime rate to 7.75% from 8.25%. Interest rates on many credit cards and home equity lines of credit are tied to the prime rate, so those borrowers will get a break on their loans.
The Fed’s action was candy to the stock market. The Dow Jones industrial average, which was up about 70 points at the time of the Fed decision, ended the day up 335.97 points, at 13,739.39. The broader Standard & Poor’s 500 index climbed 2.9%, and the Nasdaq composite index gained 2.7%.
The bond market, meanwhile, was buffeted by the Fed’s move. The yield on the 10-year Treasury bond, which influences the rates offered on fixed-rate mortgages, edged up -- the opposite of the response the Fed wanted.
The cut in the federal funds rate was the first since June 2003, when the Fed was wrapping up a 2 1/2 -year round of cuts intended to pull the economy out of the 2001 recession and help it cope with the aftermath of the 9/11 terrorist attacks. Tuesday’s discount rate cut was the second in as many months.
The Fed’s conduct during the credit crisis has been distinctly different under its current chairman, Ben S. Bernanke, than it probably would have been under his predecessor. Alan Greenspan appeared to revel in crises and in dramatic policy moves, including rate changes made between the Fed’s regularly scheduled meetings, when rate moves are customarily announced.
By contrast, Bernanke has moved slowly and, until now, much more incrementally.
Bernanke and his colleagues barely mentioned the credit crisis in the statement they issued after their early August meeting. When they were finally forced to recognize the danger in mid-August, Bernanke went out of his way to avoid cutting the federal funds rate between meetings.
Instead, he turned to the little-used discount rate and the Fed’s ability to lend directly to banks. The central bank sliced the rate by half a point and talked up the idea of banks’ borrowing from the Fed, which is rare. Daily borrowing at the discount rate increased to $7 billion a week ago from a mere $4 million last month.
The arrangement had the advantage of sending money directly to those institutions in need of it. By contrast, a cut in the federal funds rate generally spurs the overall economy, and its effects cannot be directed at any particular sector or firm.
In addition, the Fed took the unusual step of joining other bank regulators in encouraging lenders to work with troubled borrowers to minimize defaults and foreclosures.
“The subtext here is that Greenspan didn’t mind being considered the man who saved the world,” said Swonk, the Chicago economist. “Bernanke is a much more behind-the-scenes person who wants people to believe that the Fed as an institution will do the right thing no matter who is in charge.”
In aggressively cutting rates now, including the federal funds rate, Bernanke appears to be listening to the advice of former fellow academic and Fed governor Frederic S. Mishkin, who has pushed the idea that the central bank could prevent substantial economic damage from a severe housing slump by cutting rates steeply even before the slump’s effect on the broader economy is apparent.
The last time the Fed shifted from keeping the funds rate up after a series of increases to cutting it by half a point was in January 2001, in the midst of the dot-com stock bust.
But not to be pushed too far, Bernanke appears to have made sure the Fed’s new statement reminds Americans that the central bank’s job is to both ensure growth and control inflation.
“Developments in financial markets . . . have increased the uncertainty surrounding the economic outlook,” the Fed’s interest rate committee said. “The committee will . . . act as needed to foster price stability and sustainable economic growth.”
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(BEGIN TEXT OF INFOBOX)
Financial score card
The Federal Reserve’s half-point cut in its benchmark short-term interest rate will filter through financial markets and the economy, creating winners, losers -- and uncertainty.
FED’S KEY RATE
4.75%
The decline from 5.25% is the first cut since 2003. It will help banks by lowering the cost of money -- at the expense of savers and money-fund investors.
PRIME LENDING RATE
7.75%
Banks matched the Fed, dropping the prime rate half a point. That will cut the cost of many consumer loans, including home-equity credit lines.
MORTGAGE RATE
6.31%
That was the average 30-year home loan rate last week. Policymakers want to help the housing market, but it isn’t certain their move will lower mortgage rates.
THE DOW’S JUMP
2.5%
The stock market roared ahead, with the Dow up 335.97 points to 13,739.39, as the Fed’s rate cut eased fears that the economy could slide into recession.
