Fed Cuts Key Interest Rate By Quarter Point; Stocks Fall
Board Cites Slowing Growth but Gives No Sign of Future Cut

By Neil Irwin
Washington Post Staff Writer
Wednesday, December 12, 2007

The Federal Reserve cut a short-term interest rate yesterday to try to keep problems in the housing and mortgage markets from dragging the nation into recession, but Wall Street judged the move as too timid and financial markets tanked.

The Fed's policymaking committee cut the federal funds rate, at which banks make overnight loans to each other, by a quarter percentage point, to 4.25 percent. The third rate cut this year is likely to trickle through to interest rates on credit cards, business loans and some adjustable-rate mortgages.

But investors had hoped for a half-point cut, or at least a clearer signal that the central bank will cut rates again in the future, and stocks plummeted. The Dow Jones industrial average closed down 294 points for the day, a 2.1 percent drop.

"Wall Street wanted a decisive move and they didn't get it," said Robert Dye, a senior economist at PNC Financial Services Group. Money poured into safe U.S. government bonds -- two-year Treasurys had their biggest rise in three years -- on increased fears of a recession.

In a statement accompanying the rate cut, the Fed policymakers acknowledged that the economy is getting weaker. "Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending," said the release from the Federal Open Market Committee.

But the committee did not explicitly change its view of how the risk of inflation is balanced against that of slower growth, which would have indicated a strong likelihood that it will cut rates again at its Jan. 30 meeting.

It appeared more inclined to keep its options open. Fed leaders, based on their recent speeches, view this to be a unique and uncertain time for the economy and have said they want to be as flexible as possible.

Chairman Ben S. Bernanke is "slowly but surely taking interest rates down," said Robbert Van Batenburg, head of research at Louis Capital Markets. "The message he's trying to convey to the markets is that he is not overreacting."

Wall Street was also disappointed that the Fed did not take any action to ease the problem of banks being reluctant to part with their cash -- a shortage of liquidity in the financial system that has made certain kinds of borrowing more expensive despite the rate cuts.

Leaders of the central bank have been working on ways to improve liquidity, according to a recent speech by Vice Chairman Donald L. Kohn, but solutions are tricky and can have unintended consequences. The central bank could announce such moves down the road despite not disclosing any in its announcement yesterday.

"It's clear that they are exploring their options," said Peter Hooper, chief economist of Deutsche Bank. "They want to do something to help ease the tightening of financial conditions."

The decision was not unanimous. Eric S. Rosengren, president of the Federal Reserve Bank of Boston, voted to cut the federal funds rate by a half-point. At the previous meeting, on Oct. 31, there was also a dissenter, Thomas M. Hoenig of Kansas City, who favored no rate cut at all.

The dissents in opposite directions suggest that Fed leaders have more varied views than usual on which policy to pursue -- differences that may boil down to how likely they think it is that problems in the credit market will slow the economy significantly next year. The differences appear to come out of the same uncertainty that has made forecasting such a challenge.

"There's obviously a camp within the Fed that is very concerned about inflation and a camp that is more concerned about the downside risk of growth," said PNC's Dye.

Starting in July, a rapidly deteriorating housing market in the U.S. caused massive losses and uncertainty about risky, complicated debt securities around the world. Some of the world's largest financial institutions have taken multibillion-dollar write-downs from these losses. This week, the giant Swiss bank UBS joined the list, writing its investment portfolio down by $10 billion.

The credit turmoil has caused the housing market to tighten further, and while the economy grew at a speedy 4.9 percent annual rate in the third quarter, it is slowing now and is widely expected to slow further in 2008. The odds that the United States will experience a recession have risen sharply in recent months, according to surveys of economists.

Bernanke, navigating his first crisis as chairman, led an aggressive half-percentage-point interest rate cut in September, trying to ease fears of a recession. The Fed cut rates again, by a quarter-point, on Oct. 31, though that decision was a "close call," according to minutes of the meeting.

At the time, the policymakers sent strong signals they were disinclined to cut rates again -- that the risks of higher inflation and lower growth were "roughly balanced." But since then, conditions in world credit markets have worsened significantly.

Indeed, lenders are charging higher interest rates for many kinds of loans, including short-term loans between banks, that have counteracted the impact of the Fed rate cuts and made credit less available. That was probably part of the central bankers' rationale for cutting again, economists said.

But it also viewed its previous rate cuts as "front-loading" its efforts to prevent a recession, economists said, which may be why it made a smaller cut yesterday. "They've now cut a full percentage point at three meetings," said Vincent Reinhart, a resident fellow at the American Enterprise Institute who was until recently a senior economist at the Fed. "They want everybody to look at the cumulative policy action."

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