Fed disappoints the Street
The Federal Reserve trimmed its key lending rate for the third time in a row Tuesday. But the quarter-point cut was smaller than many expected, indicating uncertainty at the central bank over how serious a threat the turmoil in the nation’s financial markets poses to the economy.
Wall Street, anxious about mounting mortgage-related losses in the banking system, was disappointed by the size of the Fed’s move. Stocks suffered their worst one-day drop in more than a month, with the Dow Jones industrials falling nearly 300 points.
The central bank’s rate-setting Federal Open Market Committee trimmed the target for the federal funds rate, which banks charge one another for overnight loans, to 4.25% from 4.5%. The Fed has now cut that rate a full percentage point since it began its current round of reductions in September.
The Fed also reduced its discount rate, the price it charges for loans it makes directly to banks, by a quarter of a point, to 4.75% from 5%.
Banks responded to the cut in the federal funds rate by lowering their prime rate, a benchmark for many business and consumer loans, by a quarter of a point to 7.25%.
Many analysts had predicted that the Fed would cut both rates by half a point, and they expressed dismay at the central bank’s decision.
“It was not as forceful as it should have been, and their statement wasn’t as forceful as it should have been,” said David Jones, chairman of Investors Security Trust in Fort Myers, Fla. “They should have said they would do what it will take to deal with the credit crisis.”
By late afternoon, Fed officials were hinting to news organizations that they were prepared to take further steps to calm the banking system, perhaps by quickly making another cut in the discount rate.
The problem is that Fed officials can’t seem to agree on how much they can do about the credit crunch created by the sub-prime mortgage crisis, analysts said. Some portrayed the cuts Tuesday as an uncomfortable compromise between two camps: one favoring a half-point reduction, the other preferring to hold rates steady.
“I think there was a fight between those who wanted to pause and not do anything, keep policy unchanged, and those who wanted to cut,” Jones said.
“What’s showing is the debate within the Fed,” said Diane C. Swonk, chief economist with Mesirow Financial in Chicago.
If it was a compromise, it was nearly unanimous. The rate committee voted 9 to 1 in favor of the quarter-point cut in the federal funds rate. The lone dissenter, Boston Federal Reserve Bank President Eric Rosengren, went on record favoring a half-point cut.
In a sign of efforts to reach a middle ground, the central bank’s statement devoted almost as many words to inflation, which has not appeared a great worry in recent months, as it did to threats to growth.
“Readings on core inflation have improved modestly this year, but elevated energy and commodity prices . . . may put upward pressure on inflation,” the statement said.
But the Fed also acknowledged that economic and especially financial conditions had deteriorated.
“Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending,” the Fed statement said, adding that “strains in the financial markets have increased in recent weeks.”
Peter E. Kretzmer, senior economist with Bank of America, said the writers of the statement took pains to avoid putting greater emphasis on the credit problem, recession or inflation.
“They went out of their way to be vague,” he said.
Until two weeks ago, it appeared that the Fed did not intend to do any more rate cutting despite growing fallout in the financial system from the housing and mortgage crisis. In a series of speeches, key central bank officials sought to downplay the need for further reductions.
On Nov. 5, Fed Gov. Frederic Mishkin told a New York audience that the central bank’s September and October cuts “reduced significantly the downside risks to growth so that those risks are now balanced by the upside risks to inflation.”
Eleven days later, Fed Gov. Randall Krozsner said, “The current stance of monetary policy should help the economy get through the rough patch during the next year.”
But in the weeks since, credit market conditions grew substantially more worrisome. Short-term interest rates on loans between banks jumped, a sign that many institutions were reluctant to lend to one another on fears that the banking system would suffer deeper losses tied to surging mortgage defaults.
As Wall Street players increasingly warned that without deep rate cuts the financial system could be imperiled, Fed Vice Chairman Donald L. Kohn -- followed by Chairman Ben S. Bernanke -- appeared about two weeks ago to side with the need for further rate reductions.
That also raised hopes that the Fed would be more aggressive in its move Tuesday, particularly with the discount rate, which is a tool the central bank can use to directly aid struggling banks.
Michael Vogelzang, president of investment firm Boston Advisors, said he had expected a half-point cut in the discount rate, calling such a move a no-brainer. By refusing to be more accommodative, he said, the Fed betrayed “a real anti-Wall Street” attitude.
He noted that some officials of the central bank had said publicly in recent weeks that it must be careful not to be seen as bailing out investors who had made bad decisions.
Regardless of what caused the problems in the economy, its growth appears to have slowed drastically or even stopped after booming at a 4.9% annual rate in the third quarter. Home construction has slumped, and the inventory of existing homes for sale continues to grow. Consumer spending has also slowed because of high energy prices and weakening job growth.
Economists with at least three widely followed financial firms, Merrill Lynch & Co., Morgan Stanley and Macroeconomic Advisors, now predict that data for the current quarter will show the economy shrinking for the first time since 2001.
The Fed is “playing with fire,” said Tom Di Galoma, head of Treasury trading at brokerage Jefferies & Co. in New York, citing the risk of recession resulting from tight credit.
Fed officials “don’t get it,” he said. “Financial system problems aren’t going away.”
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tom.petruno@latimes.com
maura.reynolds@latimes.com
Gosselin and Reynolds reported from Washington, Petruno from Los Angeles.
