Turmoil spurs talk of interest rate cut
As the Federal Reserve becomes more aggressive in its approach to credit problems stemming from the sub-prime mortgage meltdown, speculation is growing that the central bank will cut its target benchmark interest rate this month.
On Friday, stepping up its efforts to calm the fears sweeping the debt markets, the Fed pumped an additional $38 billion into the U.S. banking system and made a rare announcement promising more action if necessary. The move followed a $24-billion injection Thursday.
“It’s clear that the Fed is taking this seriously,” said Mario DeRose, fixed-income strategist at Edward Jones in St. Louis. “They’re trying to head this off before it has a permanently damaging impact on the economy.”
In its statement, the Fed promised to keep providing money for the banking system “as necessary,” saying banks “may experience unusual funding needs because of dislocations in money and credit markets.”
The announcement marked a sharp shift in the Fed’s stance since Tuesday, the day of its last meeting on interest rates, when the central bank expressed more concern about inflation than about a lack of credit
The Fed was successful, at least for a day, in soothing some jangled nerves.
After signs that for a second day some banks had become unwilling to make routine overnight loans to other banks, the Fed’s injection of cash Friday created, if anything, a temporary oversupply of money available for such loans. Short-term interest rates tumbled.
In the stock market, the Dow Jones industrial average, which had plunged 387 points Thursday and was down 213 points early Friday, recovered to close Friday down 31.14 points, or 0.2%.
But the financial markets’ underlying concerns remained, and experts said pressure was building on the Fed to cut rates in coming weeks.
“The infusion of cash was clearly helpful,” said economist Ed Yardeni. “But if they really want to signal that they’re now focused on a response to the financial contagion, their policy has to move more aggressively toward lowering interest rates. They’ve always done this in the past.”
Trading in short-term interest rate futures Friday afternoon implied that investors believed there was a 32% chance the Fed would lower rates this month, although its next scheduled meeting is not until Sept. 18. At one point the implied chances of an August rate cut hit almost 90%.
“The odds of the Fed easing have grown,” said Joseph Lavorgna, chief U.S. economist at Deutsche Bank Securities in New York.
The Fed has not cut rates between normally scheduled meetings since Sept. 17, 2001, less than a week after the 9/11 attacks.
But other experts disputed the need for a rate cut, saying it would be seen as a bailout by the central bank of investors and financial institutions that took undue risks.
“I’m really proud of the Fed right now,” said Brian Wesbury, chief economist at First Trust Advisors in Lisle, Ill. “They’re doing what they need to do to make sure the system operates, but they’re not going too far and overreacting.”
The upheaval in the financial system springs from the downturn in the sub-prime mortgage market. The surge over the last few years in sub-prime loans -- those made to borrowers with weak or spotty credit histories -- began backfiring last year as defaults rose.
Investors across the globe who loaded up on sub-prime-backed bonds have suffered sharp losses. For some the pain was exacerbated because they had borrowed heavily to boost returns, which instead magnified the losses when the securities slumped in value.
Several hedge funds, most notably two run by Wall Street giant Bear Stearns Cos., suffered heavy losses, causing credit for some borrowers to tighten as investors recoiled from corporate junk bonds and other risky investments.
The U.S. credit markets had appeared to stabilize this week but were thrown off guard Thursday when France’s biggest commercial bank said it was barring withdrawals from three investment funds that held mortgage-backed securities.
That prompted banks in Europe and then the U.S. -- apparently spooked by the widening sub-prime fiasco -- to hold on to their reserves rather than lend them to their fellow banks. The Fed and other central banks responded by rushing unusually large sums of money into their financial systems Thursday.
The scenario repeated itself Friday. The Fed injected more money after its benchmark interest rate, known as the federal funds rate, shot above the central bank’s 5.25% target level.
The federal funds rate is the rate at which banks borrow from one another to maintain sufficient reserves to meet obligations such as demands by depositors to withdraw money.
After the Fed’s action Friday, which came in three parts, the federal funds rate plunged from about 6% to as low as 1% late in the day. Fed watchers said the central bank merely overshot and would return the rate to its 5.25% target level Monday.
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Times wire services were used in compiling this report.
