Fed Cuts Interest Rate to Stem Panic

Riding on fears from the U.S. subprime mortgage crisis, a worldwide stock sell-off has involved some of the worst market declines since Sept. 11, 2001.
By Neil Irwin and David Cho
Washington Post Staff Writers
Wednesday, January 23, 2008

The Federal Reserve slashed a key interest rate by three-quarters of a percentage point yesterday, a bold action designed to prevent steep losses in world stock markets from causing an all-out panic.

The rate cut, the largest in 24 years, soothed financial markets. The Dow Jones industrial average fell 1.1 percent, far less than the drops of 7 percent and more that staggered Asian and European markets earlier in the week. After the cut was announced, stock prices moderated in Europe and Asia.

Investors in futures markets are betting there is a strong likelihood that the Fed will cut rates again at its regularly scheduled meeting next week.

The cut in the federal funds rate, to 3.5 percent, should make it cheaper for consumers to borrow money with credit cards or through home-equity loans, or for businesses to take on loans to expand. It should also lead to lower rates on most adjustable-rate mortgages, though it is less likely to affect rates for long-term, fixed-rate home loans.

The cut did not immediately restore confidence to key segments of the debt markets, which are at the root of the problems threatening the economy with recession. There is also increasing concern in the markets that the tax cuts and other stimuli being discussed by President Bush and Congress will not ease the underlying credit crunch.

"The financial system has been infected," said Mark Zandi, chief economist of Moody's Economy.com. "Providing tax cuts and lower rates gives policymakers more time to solve the problem, but it doesn't heal the infection."

Yesterday's rate cut was dramatic for its scale; after the Sept. 11, 2001, terrorist attacks, the Fed cut rates by only half a point.

Fed leaders decided not to wait until next week's meeting to act. Although they worried that they might be seen as overreacting to stock-market volatility, they figured there was even greater danger if they did not move. Left unchecked, a hard-to-reverse cycle could set in with giant worldwide losses leading to a severe recession in the U.S. economy.

The central bank cut the rate "in view of a weakening of the economic outlook and increasing downside risks to growth," the Fed's policymaking committee said in a written statement. Credit is becoming harder to obtain, the housing contraction is worsening, and so is the labor market, the statement said. It said that Fed leaders expect inflation to moderate in the coming quarters, and that they "will act in a timely manner as needed to address" financial and other risks, both signals that the central bank is inclined to continue cutting rates.

The latest rate cut was on top of a full percentage-point reduction that the central bank enacted over its previous three meetings.

In the view of Fed leaders, the U.S. economy is slowing so that a large interest rate cut was justified by conventional economic analysis. But it was the crisis in financial markets and mounting gloom that created a reason to enact the cut between meetings, a practice that Chairman Ben S. Bernanke resists.

In the view of Fed leaders, a decline in the stock market is not, in and of itself, a reason to cut interest rates. In this case, the policymakers viewed the declining stock prices around the world not so much as an inherent problem but as emblematic of declining confidence in the financial system.

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