Fed Cuts Interest Rates in Bid to Spur Economy : Finance: Quarter-point reduction in funds rate is key shift from anti-inflation strategy. Dow hits record high.
Faced with mounting signs of a weakening economy, the Federal Reserve Board cut interest rates Thursday for the first time in nearly three years, a critical shift in the central bank’s strategy that analysts believe will move its focus from fighting inflation to stimulating the economy.
At a closed-door meeting of its top policy-making committee, Federal Reserve officials voted to reduce the benchmark federal funds rate by 0.25 of a percentage point, from 6% to 5.75%.
The reduction in that short-term rate will lead to lower rates for consumers and businesses as well, providing a fresh stimulus to an economic recovery that seems increasingly sluggish. In fact, some leading commercial banks almost immediately announced a similar quarter-point reduction in their prime lending rates, which in turn determine rates charged on many credit card and other adjustable-rate loans.
The action was widely anticipated by the nation’s financial markets, where many traders bet heavily that the central bank had to move sometime this summer to head off a recession. The news that Wall Street had bet the right way sent the market surging again to a record on Thursday. After the Federal Reserve announced its action in midafternoon, the Dow Jones industrial average jumped 48.77 points to close at a new record of 4,664.
Also, in a move suggesting coordination by the two economic allies, Japan’s central bank announced this morning it was also easing monetary policy and planning to guide interest rates lower to help Japan’s tottering economy. A key Japanese stock index soared more than 4% in morning trading on the news.
Still, Thursday’s action by the Fed was a cautious one, in keeping with Fed Chairman Alan Greenspan’s gradualist approach to monetary policy. The central bank did not report the vote tally on the rate cut by the Federal Open Market Committee--the 12-member panel that determines interest rate policy. That information will not be available until August. But analysts believe that the move represents a compromise--perhaps engineered by Greenspan--between officials fearful of a recession and who thus wanted a larger, half-point cut, and conservatives on the committee who believed that the Federal Reserve should have waited longer to see if the economy is really in any trouble. The fact that it did not reduce the discount rate--the rate the Fed charges commercial banks for short-term loans--is another sign that the central bank has decided to take a go-slow approach to its strategy of easing.
“I think it was an appropriate move. It indicated that the Fed is on top of the situation, but that it is not overreacting,” noted Robert Dederick, an economist with the Northern Trust Co. in Chicago.
Still, the federal funds rate, the rate commercial banks charge each other for overnight loans, is widely considered the central bank’s most powerful policy instrument. And analysts said that it was the change in direction of policy--rather than the size of the move--that is significant. It was the first cut in the federal funds rate since Sept. 4, 1992.
“This move is probably a compromise but it does mean the Fed has shifted its emphasis from inflation fighting to a recognition that the risk of a recession is high enough so that we need to take out an insurance policy on the economy by cutting rates,” observed Ross DeVol, an economist at the WEFA Group, an economic forecasting firm in Bala Cynwyd, Pa.
“It’s the first of several moves,” predicted Allan Meltzer, an economist at Carnegie Mellon University in Pittsburgh and chairman of the Shadow Open Market Committee, a private group that tries to monitor and predict Federal Reserve policy.
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The central bank stressed its role as the nation’s guardian against inflation even as it announced its rate cut. In a brief statement, the Federal Reserve said that it felt it was time to ease rates because “inflationary pressures have receded enough to accommodate a modest adjustment in monetary conditions,” thanks to “the monetary tightening initiated in early 1994” by the Fed.
But the move still marked a reversal of an 18-month Federal Reserve campaign to tighten monetary policy to slow down the economy and head off the threat of inflation. Reacting to rapid economic growth, the central bank began raising rates in February, 1994. Over the next 12 months it hiked the federal funds rate by three percentage points, from 3% to 6%.
But as the central bank kept ratcheting rates up throughout 1994 and early 1995, economists grew increasingly critical of its strategy, warning that the central bank seemed overly concerned by the specter of inflation, despite the fact that the long-feared surge in prices had not occurred. By last winter, some economists began to predict that the Fed was setting the stage for a recession.
Political leaders also have become increasingly uncomfortable with the Federal Reserve’s inflation-fighting campaign. To be sure, Clinton Administration officials have tried their best to avoid public criticism of the bank’s past moves.
Thursday’s action elicited a supportive but non-controversial joint statement from the White House and Treasury. “We expected this move so we’re treating it sort of like a non-event,” said one official.
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But other Democrats have openly complained that the central bank’s actions threatened to bring on a recession. And, given the fact that there is a lag time of about six months before Fed actions have an impact on the economy, Democrats were eager for the central bank to move this summer to buoy the economy early next year.
Earlier this week, House Minority Leader Richard A. Gephardt (D-Mo.) wrote an open letter to Greenspan calling for a rate cut before it’s too late to stave off a recession. “Considering the length of time it takes for a change in monetary policy to affect the economy, this situation clearly calls for lower interest rates now,” Gephardt wrote.
New economic data released earlier in the day Thursday seemed to confirm that it was time for a move. The government’s main forecasting gauge, the index of leading economic indicators, fell 0.2% in May, the Commerce Department said Thursday, the fourth straight monthly decline in the index.
What’s more, many economists believe that the economy may actually have dipped into negative territory during the second quarter, which just ended. And, after 1994’s rapid, 4.1% growth rate, growth for the remainder of 1995 is expected to be tepid at least until businesses work off excess inventories that are now depressing sales and production levels.
