Fed Cuts Benchmark Rate to Its Lowest Since 1962

The Federal Reserve cut the nation’s benchmark interest rate a half point to a four-decade low of 2.5% on Tuesday in its second effort in a month to protect the already weak U.S. economy from crippling damage stemming from the September terror attacks.

The reduction nudged short-term rates below inflation for the first time since the early 1990s, effectively assuring that the real cost of loans at those rates would be zero. It signaled anew the Fed’s readiness to take whatever steps are necessary to prop up the economy--and suggested the central bank is frustrated that its actions have not yet had a greater effect.

The latest cut came as the White House and Congress prepared to weigh in with an economic rescue package of their own. President Bush and congressional leaders are fairly champing at the bit to act, restrained only by Federal Reserve Chairman Alan Greenspan’s calls for caution.

Some analysts took measure of the economy’s problems Tuesday from the dimensions of the proposed solutions. “They show we’re in recession, period,” said Paul A. McCulley, chief economist with Pacific Investment Management Co., a Newport Beach-based mutual fund. “It’s not a risk. It’s not a probability. It’s a fact.

“When you’re in a recession, you’re supposed to get aggressive, anti-recessionary policy,” he said.

“Aggressive” is what the country got. The Fed’s policymaking Federal Open Market Committee cut the target for the so-called federal funds rate, the interest banks charge each other for short-term loans, for an unprecedented ninth time this year. The Fed has never set the target as low since adopting it as the chief tool of central bank policy around 1990. The monthly average for the rate has not fallen as low since John Kennedy was president in May 1962.

“The terrorist attacks have significantly heightened uncertainty in an economy that was already weak,” the Fed said in a statement accompanying its decision. “Business and household spending as a consequence are being further damped.”

The drumbeat of rate cuts is intended to rekindle economic growth by making it cheaper for American households and businesses to borrow, buy and invest. And it has done some of that.

Within minutes of Tuesday’s Fed action, J.P. Morgan Chase & Co., Bank of America Corp. and Bank One Corp. cut their prime lending rates for their most credit-worthy corporate customers from 6% to 5.5%. They were expected to reduce other rates soon, and other banks almost certainly will follow.

Stocks dipped, then rose, on news of the central bank action. The Dow Jones industrial average ended up 113.76 points, or 1.3%, at 8,950.59, while the tech-heavy Nasdaq composite index inched up 11.87 points, or 0.8%, to 1,492.33.

Since January, Fed rate cuts have helped nudge down home mortgage rates, setting off a mini-boom in mortgage refinancings.

Refinancings soared to their highest levels of the year after Sept. 11 as interest on a 30-year fixed-rate mortgage fell to 6.72% last week from 6.89% the week before the attack, according to Freddie Mac, the government-backed mortgage finance firm. Analysts predict refinancings will total $875 billion or more this year, topping the 1998 record of $720 billion, as consumers scramble to extract cash from their homes or lower their monthly loan payments.

“Frankly, I’m a little surprised by the strength of it,” acknowledged Robert Van Order, Freddie Mac’s chief economist.

But Fed rate cuts have had a distinctly less-than-hoped-for effect on the economy as a whole. Even such cautious economists as former Fed Chairman Paul A. Volcker now believe the economy has slipped into a recession.

Volcker told a New York audience Tuesday that he had hoped consumer spending would tide the country over what appeared until recently to be a business-only recession. But with the Sept. 11 attacks and the threat of military retaliation, he said: “Finally the consumer has got to be worried. The only question is how deep and how persistent” the resulting recession will be.

Analysts said at least part of the reason the Fed’s recent rate reductions have not carried their expected punch is that corporate America already had over-borrowed and had little appetite for new loans at any price.

These analysts said that by now reducing interest rates below the inflation rate, the central bank was trying to make companies an offer they can’t refuse.

“What the Fed is saying is, ‘We’re going to ease your debt burden,’ ” said Dominic Konstam, a bond strategist at Credit Suisse First Boston Corp. in New York.

At 2.5%, the new fed funds rate is slightly below August’s 2.7% so-called “core” inflation rate, which excludes volatile food and energy prices. That means that in real, or inflation-adjusted, terms, the interest on loans made at that rate is zero or negative. The fed funds rate was last negative in 1992 and 1993, when the country was trying to emerge from the post-Gulf War recession.

Analysts said the fact that the real funds rate is negative does not mean the Fed has run out of ways to affect the economy.

“It doesn’t in any way negate the effect of further rate cuts,” said Mickey D. Levy, chief economist of Bank of America Securities in New York. “We’re not in a Japan situation.”

But some economists do worry that the Fed could encounter a serious limit on its power as it cuts the unadjusted funds rate closer and closer to zero.

“You have to assume that at 1.5% or 2%, they’d grow reluctant to do much more cutting,” said former Fed Vice Chair Alice Rivlin. “In that situation, they might get worried about running out of room to cut more.”

The concerns also have helped fuel a furious debate among congressional leaders and administration officials over new tax cuts and additional government spending aimed at helping the economy and easing the pressure on the Fed. The debate appeared no closer to resolution Tuesday despite a new pledge of goodwill and bipartisanship all around.

“There is agreement that we’ve got to come together with a vision about how big the package ought to be, to make sure that we affect the economy in the short-run in a positive way, but don’t affect it in the long-run in a negative way,” Bush told reporters after meeting with congressional leaders Tuesday.

But there was plenty of disagreement over the particulars:

* Size: Senate Finance Committee Chairman Max Baucus (D-Mont.) and the committee’s ranking Republican, Sen. Charles E. Grassley of Iowa, said they would support a package of about $50 billion but no larger.

In part, they are worried by new House and Senate budget committee predictions that the government’s fiscal 2002 surplus, which was recently thought to be $176 billion, will be only $52 billion. But House Majority Leader Dick Armey (R-Texas) suggested that he would be satisfied with nothing short of a $150-billion package.

* Content: Generally, administration officials and congressional Republicans want new tax cuts, especially for business. By contrast, congressional Democrats want aid targeted on working-class and lower-middle-class Americans who generally didn’t benefit from the tax rebate approved earlier this year.

R. Glenn Hubbard, chairman of Bush’s Council of Economic Advisors, told a congressional committee Tuesday that the only things that would help the economy would be reductions in the corporate income tax rate and other business tax breaks such as accelerated depreciation and expensing. Such proposals are anathema to most Democrats.

* Timing: Generally, Democrats want temporary tax cuts or spending increases. A variety of Republicans, including Hubbard and Armey, indicated Tuesday that any additional tax cuts must be permanent.

The two sides are waiting for Greenspan to signal that he will accept a new tax-cut-and-spending package. The Fed chairman told key senators last week that Congress and the White House should go slow in assembling a rescue package.

Greenspan warned that an overly large plan could undo its intended effect by spooking bondholders about the danger of inflation and driving up long-term interest rates.

Some observers said that Greenspan, who until recently was Washington’s leading--and virtually unquestioned--economic policymaker, is reluctant to cede power, especially to Congress.

“He still believes that Fed policy should be the straw that stirs the drink,” said Pimco’s McCulley. Greenspan is scheduled to meet behind closed doors with congressional leaders again this afternoon.

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Times staff writers James Gerstenzang, Janet Hook and Warren Vieth in Washington and Thomas Mulligan in New York contributed to this report.