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Rate cut calms markets; long-term fears smolder

Times Staff Writer

The Federal Reserve, dispensing with caution and ordering a steep interest rate cut, succeeded Tuesday in curbing an incipient panic in global stock markets.

But interest rate cuts, which the Fed signaled its willingness to carry further in the weeks ahead, address some but not all of the sources of trouble in the economy both here and abroad, analysts said.

The three-quarters-of-a-point cut to 3.5% in the federal funds rate -- the largest one-time reduction in almost two decades -- helped avert an immediate crisis in the U.S stock market. Although the bellwether Dow Jones industrial average initially tumbled 465 points despite the Fed’s surprise announcement before the opening bell, the index rallied to end the day down 128 points.

The Fed’s action, which slashed the interest rate that banks charge each other for short-term loans, had an even more positive effect in Europe: Falling markets reversed course and closed higher for the day.

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Economists remained deeply divided, however, on whether the central bank’s action would have a lasting effect on the combination of problems dogging the nation: the sub-prime mortgage crisis, the fall in housing prices and growing liquidity problems among some of the nation’s largest banks and other financial institutions.

Ed McKelvey, a senior U.S. economist at Goldman Sachs in New York, said rate reductions could help by making it easier for consumers to keep buying and by easing the pain when rates on adjustable sub-prime mortgages rise.

But Stephen Roach, chairman of Morgan Stanley Asia, took a distinctly different view.

“I do not believe that aggressive Fed rate cuts will resolve the extreme imbalance between supply and demand in the U.S. property market . . . nor restore the functioning of the credit markets to their pre-crisis state,” he said in a message from the World Economic Forum in Davos, Switzerland.

Until now, the Fed has generally moved slowly in reacting to the nation’s spreading economic problems.

For much of last year, Fed officials predicted that the sub-prime crisis would remain confined and that the real danger to the economy was inflation, not faltering growth. When they finally changed their minds, they made a half-point cut in the funds rate at their September meeting, then followed up with two modest quarter-point reductions in October and December.

But Fed Chairman Ben S. Bernanke has apparently decided that the dangers to U.S. growth are substantially greater than the central bank had thought.

When global stock markets plunged Monday, signaling that anxiety about the economic outlook was spreading abroad, Bernanke managed to convince most of his Fed colleagues of the need for the three-quarter-point cut.

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It was the biggest single reduction in the funds rate since the central bank began using the rate as an economic management tool around 1990 and the largest inter-meeting emergency rate cut since 2001.

And the Fed signaled that the latest cut was unlikely to be its last as it grapples with the current situation. In a statement accompanying news of the reduction, central bank policymakers said “appreciable downside risks to growth remain” and they promised to “act in a timely manner as needed to address those risks.”

Fed watchers predicted the central bank would shave an additional half a point from the funds rate when its policymaking Federal Open Market Committee meets next Tuesday and Wednesday, and could ultimately drive the rate down to 2.25%. As recently as last September it stood at 5.25%.

“They’ve decided they need to cut a lot,” McKelvey said. “When they get to next week, they’re going to see data showing them the economy is continuing to slow and probably still worse market conditions. So they’re going to figure: “Why not cut a lot?”

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One of the most immediate challenges posed by Tuesday’s decision to take dramatic action in the wake of plunging securities markets is that the central bank’s mandate is to keep the economy growing as speedily as possible without sparking inflation, not to prop up the stock market.

“They’re in a tough spot,” said Vincent Reinhart, a former senior Fed staffer who is now a scholar with the American Enterprise Institute, a Washington think tank. “The problem isn’t with easing interest rates -- the economy needs that,” he said. “The problem is with timing the ease so it looks like you’re doing it explicitly to help the markets.”

But given the economy’s current situation, it is hard to disentangle what is strictly an economic problem from what’s a market one.

In its statement, the Fed said it acted because of “a weakening of the economic outlook and increasing downside risks to growth,” adding that “broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.”

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In essence, the Fed is having to tackle two problems at once. The first is the bursting of a housing bubble that appears to be causing a slowdown in consumer spending and a drop in construction employment. Together, those developments threaten a traditional recession or contraction of growth.

The second problem is the bursting of a credit bubble caused in large measure by sudden doubts about the safety of mortgage-backed securities, as loan defaults soar.

This second bubble has caused many financial institutions, reeling from losses on mortgage-backed securities, to sharply curtail their lending. That in turn threatens businesses with being unable to borrow in order to operate, and that is rattling the stock market.

Bernanke acted after foreign markets plunged, analysts said, because policymakers wanted to avoid a global financial contagion similar to the so-called Asian contagion that occurred in the late 1990s.

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Then, financial troubles in emerging markets in Thailand, South Korea and elsewhere ended up threatening economies as diverse as Russia’s and Brazil’s.

But the central bank chairman also was concerned that a U.S. slowdown would stall the economies of other countries, which U.S. policymakers have been counting on to help the nation dodge recession by being ready purchasers of American goods and services.

Not all of Bernanke’s colleagues lent their support to swift action. Eight of 10 voting members of the rate-setting committee favored the cut. But Fed Gov. Frederic Mishkin was traveling and unavailable to vote. And Federal Reserve Bank of St. Louis President William Poole voted against the move because he “did not believe that current conditions justified” a cut before the Fed’s regularly scheduled meeting, the Fed’s statement said.

Separately, the Bank of Canada lowered its key interest rate by a quarter of a point to 4% and signaled it was prepared to cut further to protect Canada from a U.S. slowdown.

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Analysts said the Fed’s decision to start cutting sharply was likely to increase pressure on the central banks of other industrialized nations to make similar cuts. But the Bank of England said it had no plans to change the date of its next rate decision -- a two-day meeting in London that starts Feb. 6.

In a related decision, the Fed’s Board of Governors approved a three-quarters-of-a-point cut to 4% in the central bank’s discount rate, the interest the Fed charges for making short-term loans to banks. Bernanke and his colleagues have been experimenting with ways to turn the discount rate into a more powerful economic management tool.

Until recently, banks have viewed borrowing directly from the Fed as an admission that they were in financial trouble and have feared that it would attract central bank regulators to carefully scrutinize them.

Critics have said that the Bernanke Fed has engaged in far too much gradualism over the last year as the combination of the sub-prime mess, the housing downturn and the credit crunch has weakened the economy. They have warned that it may be too late even now that the central bank has decided on a course of making steep rate cuts. In making their case, they have pointed to the Fed’s experience in 2000 and 2001.

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The central bank under the leadership of Chairman Alan Greenspan raised interest rates through the first half of 2000 even as the tech bubble burst and the stock market plunged, then held them at a comparatively high 6.5% through the rest of the year.

Fed policymakers eventually realized that the stock plunge was causing the economy substantial problems only at the beginning of 2001. In a dramatic turnabout, they began a rate-cutting exercise that included five half-point cuts from January to May of that year and brought the funds rate down to a mere 1.75% by year’s end from 6.5%.

But, critics point out, even with such substantial cutting the country was unable to dodge a brief recession from March to November of 2001, one that was most likely ended not by the Fed but by a burst of public consumption in the wake of the 9/11 terror attacks.

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peter.gosselin@latimes.com


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