Key Fed Rate Cut to 40-Year Low

The Federal Reserve moved aggressively again Tuesday to prop up the nation’s attack-rattled economy by cutting its benchmark interest rate to a 40-year low. It was the central bank’s 10th cut this year.

Fed Chairman Alan Greenspan and his colleagues on the policymaking Federal Open Market Committee dismissed suggestions that they throttle back on the size and pace of their rate cutting. They slashed the federal funds rate, which banks charge each other for short-term loans, half a percentage point to 2%. The rate began the year at 6.5%.

“They certainly weren’t being timid,” said John P. Lipsky, chief economist of J.P. Morgan Chase Corp. in New York. “I think they decided there’s no honor in erring on the side of caution.”

Indeed with their latest cut, Fed officials pushed the real, inflation-adjusted value of the funds rate toward negative terrain. That set up the enticing possibility of being able to borrow at rates so low that inflation would offset the interest costs.

“In effect, it’s giving away money,” said Robert E. Litan, economic studies director at Brookings Institution, a Washington think tank.

Of course, average Americans can’t borrow at the fed funds rate, and the loan rates and credit charges they do face have not dropped anywhere near as steeply. For example, though the Fed has chopped a full 4.5 percentage points from the funds rate since January, the rate on a typical 30-year fixed mortgage has declined less than a point.

Nevertheless, analysts say the Fed’s rate-cutting campaign has produced results ordinary people can see. It spurred a mortgage refinancing boom that is likely to hit a record $1 trillion by year’s end. It contributed to an unexpected burst in auto sales last month that was fueled by car makers’ heavily promoted interest-free financing deals.

“It’s unambiguously provided a tonic for housing and cars,” said Paul A. McCulley, an economist and fund manager with Pacific Investment Management Co. in Newport Beach.

Despite such bright spots, however, the economy has turned out to be in much worse shape than analysts and policymakers thought even in the immediate aftermath of the September attacks, and the news has only been getting bleaker.

In the last week alone, government and research groups said that unemployment jumped to a five-year high of 5.4% in October while consumer confidence fell to a 7 1/2-year low. In what most analysts interpreted as the first stage of full-blown recession, the nation’s gross domestic product, the value of its output of goods and services, contracted from July through September, its first quarterly decline since 1993.

Fed policymakers acknowledged the problems in a statement accompanying the rate cut. “Heightened uncertainty and concerns about a deterioration in business both here and abroad are damping economic activity,” they said.

In what has become a familiar refrain, the central bank signaled it was ready to cut rates still further. “The risks are [still] weighted mainly toward conditions that may generate economic weakness,” they said.

Stocks and bonds rose on the Fed announcement. The Dow Jones industrial average finished up 150 points to its highest close since the Sept. 11 attacks. The tech-heavy Nasdaq composite index rose 41.43 points.

But investor reaction appeared tempered, in part out of realization that the Fed is running out of room to act, and in part out of frustration that Washington seems unable to agree on how to employ its other major economic policy tool, fiscal stimulus.

Senate Democrats announced Tuesday that they would press for passage of a partisan economic stimulus package. President Bush threatened to veto any bill that increased spending for homeland security beyond what Congress has already provided.

“At the moment, monetary policy looks like it’s the only game in town,” said William Cheney, chief economist of John Hancock Financial Services in Boston.

The Fed has wielded its monetary policy tool with extraordinary fervor. Well before the September terror attacks, the central bank initiated one of its swiftest and steepest series of rate cuts ever. The last time the funds rate was below 2% was in September 1961.

But a growing number of analysts believe the Fed’s rate cuts don’t appear to be packing the same punch they once did.

Businesses, which usually leap at the chance to borrow cheap money, already have invested more in new technology than they can use. Exporters, which usually benefit from low rates because they can finance overseas sales more cheaply, have watched sales plummet because most of the rest of the world is also heading into recession. And the stock market, which usually takes off as rates fall, is still recovering from the technology bust.

“That leaves just one group standing,” said Litan, the Brookings economist. “Consumers.”

With unemployment now climbing and the uncertainties of terrorism mounting, many analysts believe consumers can no longer sustain the economy alone.

“They’re going to have to give up the ghost at this point,” said Bruce Steinberg, chief economist of Merrill Lynch & Co. in New York.

Potentially more disturbing, analysts say, the central bank is running out of room to make more cuts. “The Fed has fired most of the bullets it has, and firing the ones that remain gets increasingly complicated,” said UC Berkeley economic historian Barry Eichengreen.

Analysts said the Fed has a little more maneuvering room than the 2% figure might suggest. They can produce a potentially super-charged effect by driving the nominal funds rate below the inflation rate, and thereby offering borrowers zero--or even negative--real interest rates. This is the “free money” effect.

By some measures, the rate is already in negative terrain. The consumer price index, for example, shows that prices were 2.6% higher last month than a year ago at the same time.

But according to the measure favored by Greenspan, the so-called personal consumption expenditure deflator, the central bank is flirting along the border between negative and positive. The PCE deflator showed prices in the April-through-June quarter were 1.3% higher than during the same period a year ago.

Either way, analysts said, policymakers do not want to keep rates at or near negative levels for long. That’s because if they work, there is a danger of a rush of borrowing, a quick switch from bust to boom, and a burst of inflation.

And if they don’t work?

Then, said McCulley, “it starts to look as if the U.S. is flirting with a Japan situation,” where central bankers have been left essentially helpless after cutting rates to zero and still finding no borrowers.

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