The Fed Issues a Rate Cut Surprise

The Federal Reserve ended almost a year on the sidelines Wednesday by cutting its benchmark interest rate a surprising half-point to just 1.25% and acknowledging that it worries that the nation’s economic recovery is faltering.

The central bank’s policymaking Federal Open Market Committee acted after two months of rising unemployment, falling consumer confidence and a new nose dive by American manufacturers suggested that the economy has been unable to sustain the growth spurt it put on earlier this year.

The 12-member panel voted unanimously to cut the signal-sending federal funds rate to its lowest level since July 1961.

Policymakers suggested that the new rate cut was all that was needed to coax the country back to economic health and that no further reductions were planned.

“Today’s ... monetary easing should prove helpful as the economy works its way through this current soft spot,” a Fed statement said.

But the unexpectedly large rate cut -- and the suggestion that this was the last one -- appeared to disconcert some investors. The Dow Jones industrial average wobbled back and forth across the loss-gain line several times in the hours after the Fed decision. The Dow ultimately closed up 92.74 points, or 1.1%, at 8,771.01.

“The Fed is taking out an insurance policy against weakness in the economy that might accumulate,” said Allan Meltzer, an economist at Carnegie Mellon University in Pittsburgh who has finished the first volume of a history of the central bank.

Economists said the policymakers’ latest action was unlikely to result in steep new reductions in the rates that most Americans see.

“I don’t think they’re going to get a big drop in mortgage rates,” said Doug Duncan, chief economist of the Mortgage Bankers Assn. of America. Instead, analysts said, the central bank hoped the new cut would help revive corporate investment by lowering business borrowing costs.

The latest cut in the funds rate, the interest banks charge one another for overnight loans, is the 12th since the Fed began reducing rates in early 2001 in hopes of protecting the economy from the fallout of the tech- sector bust and stock market crash of 2000.

But it is the first since Dec. 11, when the central bank said weakness in demand for goods and services showed “signs of abating.”

In the 11 months since then, weakness in consumer demand did more than abate; it vanished in a wild frenzy of spending as Americans borrowed to buy near-record numbers of houses and new autos. But spending by businesses has shown only a slight sign of improvement.

In an encouraging sign late Wednesday, computer network giant Cisco Systems Inc. said it made a larger-than-expected profit in its fiscal first quarter ended Oct. 26, in contrast to its multimillion-dollar loss a year earlier. But economists doubted that either the Cisco news or the new Fed action spelled the start of a quick turnaround for corporate America.

“Don’t expect any sharp bounce-back in business confidence and hiring,” said Bank of America Corp. economist Mickey D. Levy. “Monetary policy doesn’t work that fast.”

The size of policymakers’ latest cut and the fact that it came when the funds rate was already at a 41-year low set off a debate over whether the Fed is truly worried about the economy or convinced that recovery is around the corner.

Optimists cited the Fed’s statement, and especially its use of the phrase “soft spot”’ to describe the economy’s condition, as evidence that there is no serious problem.

“ ‘Soft spot’ implies something temporary,” said Dean Maki, a former Fed economist who is now an economist with Putnam Investments in Boston. “They see this as a temporary deterioration in the data and believe conditions will improve in a few months.”

But pessimists said the size and timing of the cut suggested that the central bank believes the economy may be headed for trouble.

“The size alone tells you that the data was sufficiently bad that they thought they had to act decisively,” said Goldman Sachs economist Ed McKelvey. “They had all sorts of reasons for cutting only half as much.”

Fed officials and outside analysts repeatedly have said the U.S. must avoid the fate of Japan, whose central bank failed to grasp the destructive power of the country’s stock crash and real estate bust of the early 1990s and failed to cut interest rates fast enough to avert a crisis.

The Fed appeared to be acting out of concern for not repeating the Japanese experience when it repeatedly slashed the funds rate in 2001, reducing it from 6.5% to 1.75%.

But then it stopped cutting. Although minutes of some of their meetings this year show that Fed policymakers continued to study parallels between the Japanese and American stock crashes, they apparently believed they had done enough to prevent a similar economic fate. Japan’s economy has been stagnant for a decade.

Pessimists said Wednesday that the fact that the Fed resumed its rate cuts showed that the central bank had concluded it may not have done enough after all and that the United States could face a downward economic spiral similar to Japan’s.

If it does, these pessimists said, policymakers could be forced to take a series of drastic steps. Among the possibilities: reducing interests rates to near zero; enacting large tax cuts on top of those approved last year; and a Fed-engineered flooding of the banking system with credit, as occurred after the Sept. 11 terrorist attacks.