Worried Fed Cuts Key Rate Again

SOURCE: Federal Reserve Board | The Washington Post - January 31, 2008
By Neil Irwin
Washington Post Staff Writer
Thursday, January 31, 2008

The Federal Reserve cut a key interest rate yesterday for the second time in just over a week, as its leaders concluded that the distress in financial markets is a sufficiently grave threat to ordinary Americans to warrant the most aggressive campaign of rate cuts in the modern history of the central bank.

The cut came as new evidence showed that the crisis that began in complicated global debt markets has now affected U.S. households. The nation experienced its weakest rate of growth since 2002 in the last three months of 2007, the government reported yesterday.

The Fed cut the short-term interest rate it controls by half a percentage point, to 3 percent. On Jan. 22, it reduced the rate by three-quarter percentage points. In the 19 years the bank has explicitly targeted the federal funds rate, it had never cut it by that much in a single month.

The rate cuts should make it cheaper for Americans to borrow money through credit cards or to buy an automobile, and make it easier for businesses to borrow money to expand. It will likely lead to lower rates on many adjustable-rate mortgages.

The two rate cuts were meant to prevent the economic slowdown from becoming a prolonged, crippling recession. The stock market initially soared yesterday on the announcement before ending the day down modestly.

"The Fed is buying an insurance policy against a deep recession," said Arun Raha, a senior economist with Swiss Re.

The strategy runs the risk, however, of sparking inflation or limiting the Fed's options if the slump worsens.

As the financial crisis that began in the market for U.S. mortgage loans spread last fall, the Fed cut interest rates at a measured and steady pace. The moves were in line with past practice when the economy was threatened, such as during the 2001 dot-com bust, after the Sept. 11, 2001, terrorist attacks or during the savings and loan crisis that led to cuts in 1990.

Beginning in late December, however, data started to show a rapidly worsening economy, and Fed leaders concluded that they needed to get ahead of the sense of crisis that was developing.

"This is really sharp and really dramatic," said Neal Soss, chief economist at Credit Suisse. "It reflects a sense that when a threat to the economy comes from the financial system, you need shock therapy. Small doses of medicine are not effective."

A risk to this approach is that if it does not work -- if the economy slows significantly anyway -- it could undermine the Fed's credibility, and having already lowered interest rates significantly, there would not be much more for the bank to cut.

The statement of the Federal Open Market Committee yesterday indicated modest concern about inflation, indicating that Fed policymakers anticipate it to moderate in the coming quarters, which would be expected if growth remains weak, as most analysts expect.

"The inflation discussion is kind of pro forma," said Vincent Reinhart, a resident scholar at the American Enterprise Institute, who was a senior Fed staff member until September. "They're saying that sustaining an expansion is job one right now, and fighting inflation is a second-half-of-the-year problem."

There appear to be some Fed policymakers who remain deeply worried about inflation. Richard W. Fisher, president of the Federal Reserve Bank of Dallas, dissented from yesterday's decision, preferring not to reduce rates. This was the third consecutive policymaking meeting at which someone dissented from the decision.

Dissents were rare when Alan Greenspan was chairman of the central bank, especially in moments of crisis. Greenspan's successor, Ben S. Bernanke, has fostered more open deliberation in the Federal Open Market Committee, which makes rate decisions, but one of the side effects of that openness is that the committee can appear less unified.

The committee's statement did not offer a strong indication of what it will do at its next meeting, March 18. It said that "Today's policy action, combined with those taken earlier, should help promote moderate economic growth over time and to mitigate the risks to economic activity."

But it also used language, echoing its statement last week, that suggested that further rate cuts are a possibility. "Downside risks to growth remain," the statement said, indicating that the policymakers "will act in a timely manner as needed" to address risks of financial and other problems.

"My view is that they have signaled clearly a bias for continued easing but not necessarily at the same speed," Soss said. "It is signaling to the market 'please don't get in the habit of thinking we'll cut [1.25 percentage points] per week.' "

Over the next two weeks, more economic data will come out that will provide a better sense of whether the weakening of the economy at the end of the year continued into January. The January employment report will be released tomorrow, and other upcoming data include a key manufacturing index, retail sales figures and industrial production.

In late February, Bernanke will have the opportunity to tip his hand as to what comes next in his semi-annual testimony about monetary policy on Capitol Hill.

Gross domestic product, the broadest measure of economic growth, rose at a 0.6 percent annual rate in the fourth quarter, the Commerce Department reported yesterday. The weak growth stemmed from slow growth in consumer spending, a reduction in business inventories and a huge drop in residential construction, the report said. For the full year, the GDP grew by 2.2 percent, the slowest pace in five years.

Investment in residential construction fell 23.9 percent, the department said. Such a decline may be necessary for an eventual recovery, some economists said.

"Ultimately, all the Fed easing in the world isn't going to reduce the oversupply of housing units," said Keith Hembre, chief economist of First American Funds, which manages about $100 billion in assets. "The economy has to undergo an adjustment to absorb excess units. Bringing rates down will certainly work to cushion the blow, but I think really they're engaging in damage control."

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