The Federal Reserve cut its benchmark interest rate a quarter of a percentage point to a four-decade low of 1.75% on Tuesday and said it is ready to cut further to ensure the U.S. economy quickly pulls out of recession.
Fed policymakers gave a first, ever-so-tentative hint that they think the economy is recovering a bit of its old snap. But they signaled they are taking no chances with recovery; the latest cut was the 11th of the year and capped one of the most aggressive campaigns of interest rate reduction in the central bank’s history.
“Weakness in [consumer] demand shows signs of abating,” central bankers said in what amounted to their first slightly upbeat assessment of the year. But, they stressed, “economic activity remains soft.”
In acting, the Fed nudged the real, after-inflation value of the so-called fed funds rate, the interest banks can charge each other for short-term loans, to within a hair’s breadth of negative terrain. That means banks have access to what, in effect, is free money, and therefore a strong incentive to slice the rates they charge companies and consumers in order to generate lucrative new business.
Some analysts interpreted the Fed’s rate cut and its talk of continued economic weakness as a caution to investors who have begun acting as if the recently declared recession is already all but over.
“They have to worry the financial markets are getting a little ahead of themselves,” said Diane C. Swonk, chief economist with Bank One Corp. in Chicago. “There’s a lot of geopolitical risk out there [in the U.S. war against terrorism and new clashes between Arabs and Israelis] the markets don’t seem to be noticing.”
Investors appeared chastened by the Fed message. The Dow Jones industrial average fell 33.08 points, or 0.3%, to close at 9,888.37, while the Standard & Poor’s 500 Index slipped 3.17 to 1,136.76.
Analysts said the Fed decision to combine cuts and warnings with a hint of hope reflects the uncertain state of both the economy and economic forecasts.
Though the country’s economic condition is nowhere near as dark as analysts predicted in the immediate aftermath of the Sept. 11 terrorist attacks--with home and auto sales continuing to hold up surprisingly well--the economy has suffered a series of substantial setbacks.
The government said Friday that the nation’s unemployment rate unexpectedly jumped to a six-year high of 5.7% in November as employers slashed another 331,000 jobs. The nation’s total output of goods and services, originally estimated to have shrunk less than half a point during the July-through-September quarter, is now thought to have contracted at a sharp 1.1% annual rate.
The divergence of signals has sent forecasters flying off in drastically different directions. One group that includes Ian Shepardson of High Frequency Economics and Ed Heyman of ISI Group Inc., both New York-area firms, predicted this week that the economy will recover much of its lost ground and could even return to growth before the end of this year.
By contrast, analysts such as Robert S. Gay, a former Fed staffer and senior U.S. forecaster with Commerzbank Securities in New York, said the country is likely to end 2002 having not grown at all.
“Next year is going to be a mending year. Companies have a lot of debt and a lot of excess capacity they are going to have to shed,” he said.
Whatever their views, virtually all analysts believe the Fed’s rate-cutting campaign has prevented the economy from sinking further than it has. Since Jan. 3, the central bank has slashed the funds rate by 4.75 points to its lowest level since July 1961.
The funds rate cuts have pushed down long-term rates for home loans and business investment. The average rate for a 30-year fixed mortgage dropped from 7.07% at the start of the year to 6.45% in November, its lowest level in three decades, according to Freddie Mac, the government chartered corporation that buys and repackages mortgages. The rate on a high-quality, 10-year corporate bond shrank from 6.96% to 5.67%, a two-year low.
The reductions have done wonders for companies and consumers. The amount consumers paid in interest on credit cards, auto loans and revolving accounts fell 6% in the fiscal year ended in October, according to John G. Lonski, chief economist of Moody’s Investors Service in New York. The amount corporate America spent declined 3%.
“Slowly, but surely, the Fed rate cuts are letting households and corporations repair their finances,” Lonski said.
The problem is that the repair process has not occurred quickly enough to offset the combined effects of a lengthy stock slump, which erased trillions of dollars of investors’ paper profits, a capital spending spree that left corporate America with more plant and equipment than it knows what to do with, and, perhaps most important, the terrorist attacks on the World Trade Center and the Pentagon, which have added huge security concerns.
Analysts said the combination has made it particularly hard for the Fed to work its will on the economy, sparking a feverish effort by the White House and Congress to weigh in with a fiscal stimulus that would bolster the Fed moves by using tax breaks or new spending to help rekindle growth.
The effort bogged down in political clashes, but there was talk of negotiations between Republican and Democratic congressional leaders and the Bush administration over a possible compromise.
President Bush and GOP leaders have offered to drop some of their most controversial tax-cut proposals in return for Democrat agreement on other business-tax measures.
In the end, analysts said the solution to the economy’s troubles may come only with time.
Although some predict the Fed will cut the funds rate another quarter-point early next year, most believe it is near the end of its cutting campaign.
They said it could take six months to a year for companies and consumers to work out their problems sufficiently to exploit the new rates.
“The beauty of the U.S. economy is that Americans don’t dawdle in making tough economic decision the way the Japanese or the Europeans do,” said Gay, the Commerzbank executive. But “it still takes time” to work out problems.