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Fed Cuts Key Rate More Than Expected
Reduction Designed to Insulate Economy From Problems in Markets

By Neil Irwin
Washington Post Staff Writer
Wednesday, September 19, 2007

The Federal Reserve cut a key interest rate yesterday in an aggressive attempt to keep turmoil in financial markets from damaging the overall U.S. economy.

The central bank's policymaking committee cut the federal funds rate, which determines what banks pay to borrow money from each other overnight, by half a percentage point, to 4.75 percent. The rate cut, the first in four years, will eventually lead to lower borrowing costs for consumers and businesses, making it cheaper to take out a car loan or home mortgage or to invest in a business.

"Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time," the Federal Open Market Committee said in a written statement.

Wall Street had expected a cut of only a quarter percentage point, and the stock market soared on the announcement. The Dow Jones industrial average closed up 335.97 points, or 2.51 percent, to 13,739.39. The broader Standard & Poor's 500-stock index rose 43.13, or 2.92 percent, to 1519.78.

"I think they're trying to shock the patient back to life," said Ethan Harris, chief economist of Lehman Brothers. Instead of a series of measured, modest steps to try to keep the economy growing, the Fed appeared inclined to take bold action that might calm financial markets and abruptly halt any further slide in economic growth.

It normally takes a year or so for lower interest rates to stimulate the economy. But the psychological impact of such a big cut can be instant, economists said.

The committee's accompanying statement suggested that Fed Chairman Ben S. Bernanke and other policymakers are reasonably optimistic about the economy. It said that problems in the markets have "increased the uncertainty surrounding the economic outlook," but did not repeat language from a public statement in August that "downside risks to growth have increased appreciably."

Moreover, the Fed seemed to indicate more worry about the return of inflation than it did in August. "[T]he Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully," the statement said.

In that sense, the rate cut was an example of what watchers of the central bank call a "risk management" approach to guiding the nation's economy. In other words, Fed policymakers may view a recession as unlikely but still cut rates aggressively to try to eliminate even the possibility of one.

"The market should love this, not because the Fed is bailing them out but because the Fed is saying to them, 'We're cutting [a half-point] because we're doing everything we can to protect the economy,' " said Diane Swonk, chief economist of Mesirow Financial in Chicago.

Some analysts interpreted the Fed's statement to mean that Bernanke and his colleagues would be disinclined to cut interest rates again soon. "They're saying, 'Let's hit the ball out of the park and be done with it,' " Swonk said. In contrast, she said, when a central bank cuts rates repeatedly but by smaller amounts, the lack of bold action can make the actions less effective.

In an indication that Bernanke, who has been Fed chairman for just over a year and a half, was able to build consensus on the policymaking committee, all 10 members voted for the rate cut. The committee also voted unanimously to cut the discount rate, at which banks can borrow directly from the Fed, by half a percentage point, to 5.25 percent.

Business and political leaders were thrilled with the rate cuts. "Today's decisive action by the Federal Reserve to ease its monetary policies is good news for the economy and prospective home buyers seeking a piece of the American dream," the National Association of Home Builders said in a news release, and several members of Congress indicated that they approved of the action. House Financial Services Committee Chairman Barney Frank (D-Mass.), a frequent critic of the Fed, said he was "pleased."

But some economists expressed concern that the Fed may have overreacted. Unemployment, at 4.6 percent, remains low by historical standards. And oil prices are reaching all-time highs, which might eventually put inflationary pressure on the rest of the economy. Consumer spending has remained reasonably strong, despite the slumping housing market.

"If we get a few decent economic numbers in the next couple of months and some signs of inflation, all of a sudden Bernanke has put himself in a tough spot," said Richard Yamarone, chief economist of Argus Research.

There were other signs yesterday that the problems that began in the market for home mortgages and spread to a wide range of debt markets may have a limited effect. Lehman Brothers, a large brokerage, reported its financial results for the quarter that ended Aug. 31 -- an early indicator of how much the credit crisis has crimped the ability of investment banks to continue playing a key role making funding available to businesses.

The early answer: Not much. Lehman reduced the value of debt securities on its books by about $700 million, reflecting troubled markets for leveraged-buyout loans and residential mortgages. However, the firm's earnings fell only 3 percent from a year earlier, not as much as investors had expected.

Three other major investment firms report quarterly earnings this week: Morgan Stanley today and Bear Stearns and Goldman Sachs tomorrow. If, like Lehman, they report that damage from the credit crisis is manageable, the markets could get a psychological boost.

Also yesterday, the Labor Department reported that prices paid by producers of goods and services fell 1.4 percent in August and rose 0.2 percent excluding food and energy costs. The modest inflationary pressure in the producer price index could make it easier for the Fed to cut rates in the future.

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