Rate cut may not be the last
The Federal Reserve pressed ahead Wednesday with one of its most aggressive rate-cutting campaigns ever in an effort to ease the effects of a housing slump, a credit crunch and a possible recession. And the central bank left itself room to shrink interest rates again if necessary.
Brushing aside concerns that it was doing the bidding of the securities markets, the Fed cited troubled financial conditions as its primary motivation in chopping its benchmark interest rate by half a percentage point to 3% -- just eight days after making an emergency reduction of three-quarters of a point.
Only once since the early 1990s has the agency moved so swiftly to reduce the cost of borrowing.
“It’s pretty clear by now that the Fed is ready to embrace the need . . . to stem the deterioration in financial conditions,” said Robert V. DiClemente, chief U.S. economist for Citigroup Inc.
“We’re encircled with threats to growth and the Fed is saying, ‘Enough! We’re going to quarantine some of the problems and insulate the healthy parts of the economy,’ ” he said.
The Fed acted on the same day a Senate panel approved an economic stimulus package that would offer lower tax rebates -- but give them to many more people -- than a measure passed by the House and endorsed by the Bush administration.
For consumers, the latest rate cut will mean a further lowering of costs on some adjustable-rate mortgages, credit card accounts and other debt linked to the so-called prime rate, which major banks began trimming late Wednesday in lock step with the Fed’s action. The lower prime rate also will cut costs on many business loans. And fears of a recession have already sliced yields on long-term Treasury bonds, bringing rates on fixed-rate mortgages under 6%.
The lower borrowing costs theoretically will encourage spending throughout the economy. But this time economists are less certain about the future. Even with access to cheaper money, a badly shaken financial system may be slow to make new loans. A similar reluctance to act could manifest itself among consumers if sinking home prices, rising unemployment and other factors make them uneasy.
Adding to the uncertainty, the government said Wednesday that economic growth slowed abruptly in the last three months of 2007 as housing construction plunged, consumer spending slowed and businesses battened down for trouble by slashing their inventories. The country’s gross domestic product, the broadest gauge of the goods and services that the U.S. produces, grew at a mere 0.6% annual rate -- its slowest pace in five years and much lower than the feverish 4.9% rate of the previous quarter. The latest figure was only half the rate estimated on average by economists. For 2007 as a whole, the GDP grew 2.2%, its slowest rate in five years.
“Clearly, we’re an economy that is very close to a recession,” said Nariman Behravesh, chief economist at forecasting firm Global Insight Inc. “Just about all of the components of GDP were weaker, and even the bright spots -- like exports -- were glowing less strongly.”
Although the stock market had climbed Monday and Tuesday in anticipation of the rate cut, the Dow Jones industrial average still surged about 200 points after the Fed announced its action. But the market retreated after fresh worries emerged about the health of some financial firms. The Dow ended the day shedding 37.47 points, or 0.3% of its value, to close at 12,442.83.
In slashing rates so dramatically to maintain growth, the Fed has largely put aside for now its traditional concern with inflation. As recently as December, the central bank warned that “elevated energy and commodity prices . . . may put upward pressure on inflation” and asserted that “some inflation risks remain.”
But in announcing its decision Wednesday, the central bank barely mentioned inflation as a danger, saying only that it would “continue to monitor inflation developments carefully.”
For the nation’s chief inflation fighter, the change of focus could not be more stark, and the shift left some analysts worried.
If the overall economy turns out to be less troubled than the markets and the Fed now think it is, these analysts say, the combination of steep rate cuts and the pending fiscal stimulus plan could send prices into orbit.
“They’ve decided to put their concerns about growth ahead of any concerns about inflation,” said Gregory Hess, an economist, former Fed staffer and dean of the faculty at Claremont McKenna College. “They’re definitely taking a risk.”
Allan Meltzer, an economist at Carnegie Mellon University who is writing a multivolume history of the central bank, went further, saying, “I think the Fed is bonkers.”
Fed officials “frequently swear to themselves and to each other that they are not going to ease [interest rates] excessively, and then the economy slows a little and they do just that,” he said.
But the predominant view among economists and apparently among Fed policymakers is that the nation’s economy is reeling from the collapse of the sub-prime mortgage market, the bursting of a housing bubble and roiling doubts about the safety of complex securities -- many of them backed by mortgages -- that found their way into the portfolios of investors and institutions around the world.
Although in this view the combination may not have caused the economy to start shrinking, it leaves the country vulnerable to a serious downturn.
“There has been a shift from the Fed’s earlier thinking where there was a lot of emphasis on inflation risks to an emphasis on growth risks,” said Brian Sack, senior economist at Macroeconomic Advisers in Washington.
“The toxic aspect of our situation is that growth is already slowing” as these other dangers eat away at the economy, said Citigroup’s DiClemente.
In their statement accompanying the Fed’s latest action, central bank policymakers said that “financial markets remain under considerable stress, and credit has tightened further for some businesses and households.” The statement also warned that “recent information indicates a deepening of the housing contraction as well as some softening in labor markets.”
A shift in language by the Fed suggested policymakers think their rate cut last week may already be having an effect. In making that cut, the Fed warned that “appreciable downside risks to growth remain,” whereas Wednesday they dropped the word “appreciable.”
However, there have been a series of false endings to the crisis in the last year. Policymakers said for months that they thought the sub-prime mess wouldn’t spread to other parts of the financial system or the overall economy.
When that proved wrong, they suggested that one or two rate cuts would be enough to take care of the problem, but that too proved wrong.
So the Fed in its statement Wednesday left itself plenty of rhetorical room to keep cutting if conditions worsen, saying it would “act in a timely manner as needed” in response to threats to growth.
In the five months since beginning its rate-cutting campaign in earnest, the Fed has slashed the federal funds rate, which banks pay to borrow money overnight from other banks, by 2.25 percentage points from 5.25% last September. The central bank Wednesday also cut its discount rate, which banks pay to borrow directly from the Fed, by half a point to 3.5%.
The only time the central bank has slashed the federal funds rate as aggressively as it has in recent months was in early 2001 when it was trying to cope with the fallout from the technology-induced stock market bust of the year before.
Wednesday’s reduction in the federal funds rate came on a 9-1 vote, with Richard Fisher, president of the Federal Reserve Bank of Dallas, dissenting, preferring no rate change. It was the fourth straight Fed meeting with a dissent, each time by a different regional Fed bank president.
The Fed’s decision to cut rates came despite signs that inflation is beginning to pick up. The inflation index accompanying the quarterly GDP report showed prices rose at a 2.6% annual rate, up from 1% in the previous quarter. Excluding volatile food and energy costs, prices rose 2.7%.
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The Federal Reserve’s statement
The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points [0.5 of a percentage point] to 3%.
Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.
The committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.
Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, chairman; Timothy F. Geithner, vice chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.
Voting against was Richard W. Fisher, who preferred no change in the target for the federal funds rate at this meeting.
In a related action, the Board of Governors unanimously approved a 50-basis-point [0.5 of a percentage point] decrease in the discount rate to 3.5%. In taking this action, the board approved the requests submitted by the boards of directors of the Federal Reserve banks of Boston, New York, Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, Kansas City and San Francisco.