Fed Lowers Bank Rate, Shifts View On Economy
Market Turmoil Supplants Inflation as Top Priority

By Neil Irwin
Washington Post Staff Writer
Saturday, August 18, 2007

The Federal Reserve cut a key interest rate yesterday, trying to ease a worldwide credit crunch, and said for the first time that it viewed turmoil in financial markets as a major risk to the U.S. economy.

Taken together, the two moves signaled that the central bank stands ready to take serious action to prevent disruptions that began in the market for household mortgages from spreading through the economy. Stock markets worldwide rallied on the surprise announcements.

The Fed lowered the discount rate, a rate at which banks can borrow from the central bank, to 5.75 percent from 6.25 percent. The move is meant to help stabilize credit markets, but is unlikely to directly affect the interest rates paid by consumers and businesses.

The Fed's policymaking committee said that it "judges that the downside risks to growth have increased appreciably" and that it was "prepared to act as needed to mitigate the adverse effects on the economy arising from disruptions in financial markets."

Among the immediate results: The U.S. stock market had its first positive day in the past week, with the Dow Jones industrial average rising 233 points. Large companies raised $15.1 billion in debt, something they had been unable to do for days. Prices of crude oil and other commodities rose, as speculators concluded that the odds of a U.S. economic slowdown had lessened. Money flooded out of safe assets such as Treasury bills, driving down securities prices. The British stock market rose 3.5 percent, and most other European markets rose similarly.

"When you get a major panic setting in, you can have well-managed businesses with good balance sheets get stampeded out of business," said Brian A. Bethune, U.S. economist for consulting firm Global Insight, a financial forecasting and analysis firm. "With these measures, the Fed is trying to prevent that."

As financial markets became increasingly turbulent in the past two weeks, the Fed's response was reserved. It injected money into the banking system, as did central banks in other nations, but offered no signs that it was inclined to take dramatic moves to ease the credit crunch or stimulate the economy. Just 11 days ago, the Fed's policymaking committee indicated that inflation spurred by an overheating economy remained its greatest concern.

Since then, however, the markets for many mortgages and corporate debt have come to a near standstill, investors have dramatically bid up the price of safe assets, and stock values have fallen sharply in the United States and around the world. As a result, an economic downturn appears to have supplanted inflation as the Fed's greatest worry.

Fed officials had been monitoring the markets closely, considering ways they might intervene, but decided to take action only after particularly wild market swings Wednesday and Thursday.

The Federal Open Market Committee met by video conference Thursday night, a rare occurrence outside of regularly scheduled meetings, and agreed to make public its adjusted view of the economy in hopes of preventing a self-reinforcing panic from setting in the markets that could ripple through the broad range of financial decisions that businesses and individuals make.

The statement suggests that the committee has become more likely to cut interest rates at its next regular meeting Sept. 18 if the distress in financial markets continues. Such a move would lower borrowing costs to consumers and businesses and stimulate the economy.

The move yesterday would not affect borrowing costs, however, as it was more narrowly tailored to try to get credit markets working again.

The "discount window," operated by the Federal Reserve Bank of New York, is where banks needing cash can go to borrow from the central bank, simply by putting up collateral such as loans that are considered to have a low risk of default. The practice was designed to prevent U.S. financial institutions from experiencing a run on the bank.

Normally the loans are overnight; with its action yesterday, the Fed made them available for a renewable 30-day span. And it noted that home mortgages are acceptable as collateral at the discount window.

There are two basic problems transpiring in the markets. Many investors are so fearful of further losses that they are unwilling to buy mortgages or corporate debt at any price, so those markets have frozen up. And market participants of all stripes are moving money from risky assets into cash, leading to a shortage of money in the economy.

The Fed action attempts to deal with both problems. Banks can use their portfolios of mortgage-backed securities as collateral to borrow money at the now-reduced rate, freeing up more cash.

Not since 1980 has the Fed moved the discount rate but not the more widely followed federal funds rate, according to Standard & Poor's. Cutting the federal funds rate might ease the losses faced by lenders that wrote bad mortgages or companies that took on too much debt. By cutting the discount rate, the central bank is trying to manage the tricky task of keeping the financial system humming without bailing out people who simply made bad bets.

"The message to the markets in this is that to the degree some of this has been irrational, we will prevent the markets from harming themselves through their own irrationality," said Neal Soss, Credit Suisse's chief economist Neal Soss said.

In practice, there has been a stigma attached to using the discount window, and banks have rarely used it. Now, the Fed is effectively encouraging banks to do so.

"They've opened the door , and rather than have the door just ajar, now it is wide open," said Richard A. Yamarone, director of economic research of Argus Research in New York. "That doesn't mean anyone is going to show up."

The Dow ended the day up 1.8 percent, or 233.30 points, at 13,079.08. The technology-heavy Nasdaq composite index was up 2.2 percent, or 53.96, to 2505.03. The broader Standard & Poor's 500-stock index rose 2.5 percent, or 34.67, to 1445.94.

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