Fed Unexpectedly Cuts Key Rate by Half-Point

The Federal Reserve unexpectedly slashed a key short-term interest rate half a percentage point Wednesday, signaling both that the nation’s economy is in tougher shape than previously thought and that the central bank intends to keep it from sinking further.

The Fed action had urgency written all over it. It occurred between regularly scheduled meetings of the central bank, a rarity. It came in advance of Friday’s release of employment data that Fed policymakers had suggested they wanted to see before acting. And it was substantially bigger than almost anyone had anticipated.

“If they wanted to send a signal, they certainly did that,” said Mickey D. Levy, chief economist of Banc of America Securities in New York. “By this move, the Fed revealed it is deeply alarmed by the deterioration of the economy.”

Following a telephone conference call among Fed policymakers Wednesday morning, the central bank cut the fed funds rate--the interest that banks charge each other for short-term loans--from 6.5% to 6%, the first reduction in more than two years. It coupled the move with a quarter-point reduction, to 5.75%, in the largely symbolic discount rate, which the Fed itself charges banks for loans, and said that it stood ready to make a further quarter-point reduction in the discount rate shortly.

The rate cuts are designed to reassure consumers and businesses that the Fed will keep the economy growing and the financial system flush with enough cash to continue lending. Over time, the cuts are expected to reinvigorate growth by shrinking the interest that Americans pay on everything from credit cards to plant and equipment loans.

Wednesday’s action had one instant--and from the Fed’s point of view, potentially unwelcome--effect: a stock market rocket launch. The technology-heavy Nasdaq composite index leaped a record 14.2%, while the Dow Jones industrial average jumped a more modest 2.8%.

Orange County stocks also were swept up in the market’s surge. The Orange County Bloomberg index of 125 stocks, which is heavily weighted with technology issues, racked up its biggest one-day gain since it was established six years ago.

Until the stock market began sputtering last spring, central bankers had fretted that its out-sized gains were fueling a consumer buying frenzy and unsustainably fast growth.

Analysts said Wednesday’s cuts were only the first in a series that could eventually shrink the Fed funds rate to 5% or less.

“This is a Fed that’s taking out an insurance policy against recession,” said Diane C. Swonk, chief economist of Bank One Corp. in Chicago. “It’s clear it will do whatever it has to to make sure there is not a recession.”

Some analysts saw new trouble brewing in the stock market’s wild reaction. They warned that if stock prices continue rising, the Fed could face the dilemma that any downward nudge in interest rates revives the market and pushes the economy back toward unsustainably fast growth, while any upward nudge in rates sends the market and, with it, the economy into a nose dive.

But other analysts said that the central bank would cope with a zooming economy by simply reversing course again and raising rates. “This is a Fed,” Swonk warned, “that can take back what it gives.”

The cuts had another effect as well: They partially eclipsed a meeting of big-name business leaders convened in Austin, Texas, by President-elect George W. Bush.

Some analysts said the central bank intended to send a message with the cuts that the Fed, and not the White House, remains the economy’s manager-in-chief. But the incoming president insisted that he did not view matters that way.

“It was a strong statement that measures must be taken to make sure our economy does not go into a tailspin,” Bush said of the central bank’s rate decision. Such measures include both interest rate cuts and, Bush reiterated, congressional passage of big tax cuts that his administration will push.

The president-elect escalated his war of words over the economy Wednesday, asserting that the nation is in need of an “economic recovery”--an unusual claim given that virtually every analyst believes the economy is still growing, even if more slowly, and that the country remains in the longest expansion of its history.

Bush and his aides have been highlighting the economy’s weakness as part of their case for tax cuts and in order to diminish claims that President Clinton and the Democrats have been good stewards of the economy.

Wednesday’s rate reductions represented the latest leg in a long journey for the Fed and its veteran chairman, Alan Greenspan. Over the last 14 years, the bespectacled economist has zigzagged between rate cuts and hikes in an effort to keep the economy growing without the damaging side-effects of inflation and shortages.

The most recent chapter began in fall 1999, when central bank policymakers concluded that both the economy and the stock market were growing too fast for their own good, and they began raising rates to slow things down.

The increases began taking their intended toll on stocks last spring, but seemed to leave the broader economy untouched--until the last few months, when things apparently began to come unstuck all at once.

Consumers, rattled by market declines and the ambiguous results of the presidential election, did not head to the malls in predicted numbers for holiday shopping. Companies, which had been snapping up high-tech gear to improve efficiency, suddenly started cutting back.

The bad news has continued pouring in. Last week, the Conference Board, a New York business research group, said consumer confidence has plunged to its lowest level in two years.

On Tuesday, the National Assn. of Purchasing Management said U.S. manufacturing orders and output slumped dramatically in December, sending the group’s index of factory activity to its lowest level since 1991.

On Wednesday, both auto makers and construction contractors announced that their businesses had tumbled in December.

Investors and financial specialists insisted in advance of the Fed’s meeting last month that the central bank would recognize the changes in the economy and slash rates immediately. When it didn’t, the markets went into a steep dive that continued until the very moment Wednesday’s cuts were announced.

Veteran Fed watchers said the central bank had hoped to hold off acting until Friday, when the latest unemployment statistics are scheduled for release. The figures are widely considered a key barometer of the economy’s condition.

But having decided to act, the Fed sought to get the biggest bang for its buck by moving quickly and approving a substantially larger-than-expected cut, analysts said.

“They certainly caught everybody by surprise,” said Martin A. Regalia, chief economist at the U.S. Chamber of Commerce.

As it customarily does, the Fed accompanied its rate reductions with an explanation. It said in a statement that it had acted “in light of further weakening of sales and production, and in the context of lower consumer confidence, tight conditions in some segments of financial markets and high energy prices sapping household and business purchasing power.”

And it hinted at further cuts, saying the risks “are weighted mainly toward conditions that may generate economic weakness.”

But there was some evidence that the Fed acted with uncharacteristic haste Wednesday. Although it is economically inconsequential, the central bank likes to cut the fed funds and discount rates by like amounts.

However, its Board of Governors reduces the latter rate only at the request of the directors of the 12 Federal Reserve banks around the nation. The bank directors had submitted requests for only a quarter-point, rather than a half-point, cut in the discount rate, and apparently the Washington-based governors felt they could not wait to organize a second request for an additional quarter-point reduction before acting.

“This is a Fed that knew it was behind the curve and was determined to get ahead of it,” said Richard Medley of Medley Global Advisors in New York.