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Fed Slashes Key Interest Rate, and Stocks Soar
Central Bank Redefining Its Role

By Neil Irwin
Washington Post Staff Writer
Wednesday, March 19, 2008

The Federal Reserve took another aggressive step in its campaign to prevent a deep and devastating recession yesterday, cutting a key interest rate by three-quarters of a percentage point. The stock market staged its biggest rally in five years, with the Dow Jones industrial average rising 420 points.

Fed policymakers cut the federal funds rate, at which banks lend to one another, to 2.25 percent. That lower rate should ultimately make it cheaper for Americans to take out adjustable-rate mortgages and borrow money through credit cards or auto loans, and for businesses to borrow money to expand. The Fed has slashed that rate by three percentage points since September.

The rate cut was the latest measure aimed at easing the intertwined problems of a slowing economy and a crisis in financial markets. The freeze-up in world credit markets is a major cause of the U.S. economic downturn, and the slowing economy has in turn fueled further problems in those markets. The Fed is trying to halt that vicious cycle with a two-front war.

On one front, the central bank has begun redefining its role overseeing Wall Street, making emergency loans available to investment banks and taking other unconventional action to try to avert full-scale financial panic. On the other front, dealing with the overall economy, the Fed has undertaken the most aggressive interest rate cuts in its modern history.

"We are seeing a remarkably activist Federal Reserve," said Alan S. Blinder, a Princeton University economist and a former Fed vice chairman. "They are being quite creative in using both traditional weapons and inventing new ones to deal with a pretty unprecedented set of problems."

The efforts to stimulate the overall economy and thaw the financial markets are related in important ways. The problems in the financial world have made previous Fed rate cuts less effective, keeping mortgage and other consumer interest rates stubbornly high. Thus, if the Fed's elaborate efforts to get the credit markets working again succeed, the interest rate cuts will boost the economy more.

But the central bank gave indications yesterday not to expect more huge rate cuts. That is partly because of simple math -- with the federal funds rate now at 2.25 percent, there is not much more room to cut, especially at the recent pace. Another restraint is that Fed leaders are worried about inflation, which is being driven by soaring prices for energy and food on world markets.

"Inflation has been elevated, and some indicators of inflation expectations have risen," said a statement from the Fed's policymaking committee, and "uncertainty about the inflation outlook has increased." That is much stronger language about inflation than in other recent communications from the central bank, and it could signal a reluctance to take more big rate cuts unless the economy or financial markets begin to unravel even more than is currently forecast.

Two presidents of regional Fed banks, Richard W. Fisher of Dallas and Charles I. Plosser of Philadelphia, dissented from the vote to cut the federal funds rate, apparently out of concern that prices are rising too fast, showing that some on the Federal Open Market Committee are already worried that the central bank has cut rates too much.

Fed Chairman Ben S. Bernanke and his colleagues have said there is almost no home-grown inflation -- the kind driven by a too-tight job market, for example -- in the economy. Rather, they view the price increases as coming from rising prices for food and energy on global commodity markets.

Bernanke has said he expected prices for food and energy to level out this year, as futures markets are forecasting. If that proves correct, it would dampen inflation. But Fed leaders worry that as price increases for those goods filter through to other goods, Americans could get used to prices rising rapidly. Expectations of higher inflation tend to be self-fulfilling.

"The rise in inflation expectations has set a much higher barrier for more rate cuts," said John Silvia, chief economist of Wachovia.

That said, the Fed's statement indicated that "downside risks to growth remain" and that policymakers "will act in a timely manner as needed to promote sustainable economic growth and price stability." Translation: If the economy gets dramatically worse, we'll keep cutting rates.

The Fed has in the past two weeks intervened in the financial markets in dramatic fashion, using a range of tools to try to push financial institutions to have enough confidence in one another to keep the flow of credit running through the economy. It amounts to a wholesale rewriting of its role managing the financial system and has happened suddenly, with no real political debate.

The central bank is grappling with this reality: Its powers were designed to address crises in the highly regulated commercial banking system. But the current crisis is taking place in the more free-wheeling world markets for capital, where trillions of dollars are borrowed and lent.

"The evolution of the Fed is catching up to the evolution of the financial markets over the last 30 years," said David Shulman, a senior economist with the UCLA Anderson Forecast.

Bernanke has stressed creativity in the Fed's response to the faltering economy, given the complexity of the situation. Rate cuts have not stimulated the economy as much as they usually do because of the freeze-up in financial markets, and that is a major reason the Fed has tried targeted fixes for the credit markets, like special auctions to pump cash into banks. That is also a key reason Bernanke supported the economic stimulus plan passed by Congress and signed by President Bush last month.

The steep rise in the stock market yesterday -- the Standard & Poor's 500-stock index, a broad market indicator, posted its biggest percentage gain in five years -- was driven by confidence that the Fed's efforts to stabilize the functioning of financial markets were working. Lehman Brothers and Goldman Sachs, two of the major players in this new financial system, reported earnings that were better than expected. Their stocks soared 46 percent and 16 percent, respectively.

The market gains accelerated in the afternoon, soon after the Fed announced the interest rate cut, even though many on Wall Street had been expecting a cut of a full percentage point.

In Jacksonville, Fla., yesterday, Bush continued speaking optimistically about the outlook for the economy. "The key is to recognize problems and to act early, which is what we've done," the president said, adding later: "If there needs to be further action, we'll take it."

"In the long term," he said, "we're going to be just fine."

Staff writer Dan Eggen in Jacksonville, Fla., contributed to this report.

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