By Neil Irwin and Anthony Faiola
Washington Post Staff Writers
Thursday, October 30, 2008
The Federal Reserve yesterday slashed a key interest rate for the second time in two weeks, while the central bank and the International Monetary Fund moved to prevent a string of financial collapses in emerging markets.
Taken together, the announcements marked extraordinary attempts to bolster the U.S. and world economies.
"Exceptional times call for an exceptional response," said Dominique Strauss-Kahn, managing director of the IMF.
Global stocks surged on news of the Fed's rate cut, but reaction in U.S. markets was muted. The Dow Jones industrial average, which gained 889 points on Tuesday in anticipation of the rate cut, closed down 74 points, or 0.8 percent, at 8990.96. Gains in overseas markets continued today, with stocks in Japan up more than 7 percent in early trading.
The Fed's actions yesterday came barely an hour apart. First, it cut its target for the federal funds rate -- the rate at which banks lend to each other -- from 1.5 percent to 1 percent, the lowest level since the aftermath of the dot-com bubble in the early 2000s. Later, it announced it would pump up to $120 billion into the central banks of Mexico, Brazil, Singapore and South Korea. The Fed has never lent on such a scale directly to developing nations, which are seen as having a greater risk of default.
The Fed and the IMF have had high-level talks in recent days about the gravity of the situation in emerging markets and the need to respond.
Given the scope of the need, the IMF said it would offer as much as $100 billion in emergency short-term loans to developing countries. In a departure from IMF norms, the loans would be rapidly deployed and have few strings attached.
The bursting of the biggest credit bubble in world history is battering emerging-market powerhouses that only months ago were seen as pillars of global strength, sparking runs on their currencies and dramatic plunges in their stock markets. The Brazilian real and Korean won, for instance, have both shed more than 30 percent against the dollar in the past two months as panicked investors have yanked billions out of the market. Hungary, also among those countries hit hardest, has struck a deal for a loan with the IMF, and the European Central Bank said Tuesday that it would join in the $25.1 billion bailout.
Making matters worse, many financial institutions in the developing world are struggling for cash as banks in the First World, themselves facing a credit crunch, pull in their lines of credit. Governments, corporations and, in some cases, even consumers have loans and other bets denominated in dollars, making those debts suddenly more expensive as their domestic currencies have sunk against the dollar.
By offering emergency loans to the central banks in key emerging markets, the Fed and the IMF are giving institutions more power to jump-start lending in their home countries, many of which have spent billions of their reserves defending their currencies in recent weeks.
At the Fed, policymakers made clear that they view the risks facing the U.S. economy to be severe. "The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures," the Federal Open Market Committee said in a statement, unusually blunt language for such a formal statement. "Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit."
The rate cut is designed to guard against the risk of a devastating downturn. In normal times, Fed rate cuts make it cheaper for businesses to borrow money to expand and for consumers to get auto loans, home mortgages and credit card debt. But in the current crisis, with banks reluctant to lend at any price, the rate's impact is uncertain.
Nonetheless, many economists think the Fed will cut the rate again at its Dec. 16 meeting, if not before, as the economy worsens.
"We're in a downward spiral that's going to take at least six months to get through," said Kurt Karl, chief U.S. economist at the reinsurer Swiss Re, who expects the Fed to cut the rate to half a percent. "The next time they meet, the situation may be better in the credit markets, but the economy is going to be very dire."
The Fed did little to dissuade that thinking in its statement, as it indicated that inflation is likely to moderate and that it will "act as needed" to promote growth, language that leaves the door wide open to further actions. The Fed's decision to cut the rate was unanimous.
The central bank is facing a situation in which additional rate cuts are unlikely to pack much additional punch, both because rate moves normally take time to affect the economy and because credit markets remain clogged. Nonetheless, Fed leaders have felt it necessary to deploy every possible tool they have to combat the downturn.
The aggressive rate cuts -- the central bank has cut the federal funds rate to 1 percent from 5.25 percent in September 2007 -- create two risks. If the economy recovers faster than expected, it could stoke a new lending bubble, which happened in the early 2000s and contributed to the current crisis.
On the other side, if things turn out worse, the Fed could find itself with little room to maneuver -- interest rates cannot be pushed below zero (and indeed could cause problems in the functioning of money market mutual funds and other investment vehicles if brought down to zero).
"You could be left with no defense," said Richard Yamarone, chief economist at Argus Research. "What happens if the Fed does cut to zero and then the economy early next year contracts 3 or 4 percent? It has no bullets left in the chamber."
By offering new loans with flexible terms, the IMF, a multilateral lender funded largely by the world's richest nations, is effectively breaking with decades of highly methodical lending that came with tough conditions. Typically, the fund grants loans only after weeks, if not months, of negotiations, and demands major concessions from borrowing nations on spending and economic reforms.
But the crisis is such that the IMF needed to take extraordinary steps, Strauss-Kahn said. Only nations viewed as fundamentally sound and with good relationships with the fund can participate in the program.
The short-term loans would have three-month terms, in contrast with the three- to five-year terms of typical IMF loans. A formula would limit the amount each nation could borrow; Brazil, for instance, could borrow about $15 billion at once, though it could do so as many as three times a year, assuming each loan was paid back in full.
Countries deemed not to have good track records and fiscal policies, such as Argentina, Strauss-Kahn said, would not be eligible.
In an interview, Strauss-Kahn said the fund would probably need more money from its international donors to address the mounting problems in emerging markets. The IMF has about $200 billion, with access to another $50 billion, to lend. But as the crisis has hit emerging markets, the IMF has promised $2.1 billion to Iceland, $16.5 billion to Ukraine and $15.7 billion to Hungary. Deals are pending with Pakistan and others.
British Prime Minister Gordon Brown has called for China and the oil-rich Gulf states to contribute new, vast sums to the IMF. Strauss-Kahn would not confirm that the fund had entered into talks with those nations for an infusion, but he said he would "welcome" a move by nations with "big pockets" to aid those now in crisis.