A Nov. 7 article on the Federal Reserve's interest rate cut incorrectly said the Fed's 0.75 percent discount rate was the lowest in history. During part of World War II, the rate for banks borrowing money directly from regional Federal Reserve banks and using federal government securities as collateral was 0.5 percent. (Published 11/8/02)

Increasingly worried that U.S. economic growth is close to stalling, Federal Reserve officials yesterday cut a key short-term interest rate to its lowest level in more than four decades to help lift the economy over what they called "this current soft spot."

The Fed's top policymaking group, the Federal Open Market Committee, cut its target for overnight interest rates by half a percentage point, to 1.25 percent. Separately, the Federal Reserve Board reduced a companion rate governing what banks pay when they borrow from regional Federal Reserve banks to 0.75 percent, the lowest in the Fed's 89-year history.

Those extraordinarily low rates are a sign of how seriously Fed Chairman Alan Greenspan and other Fed officials regard the failure of the U.S. economy to sustain a stronger recovery this year. They do not expect the economy to slip back into recession, but they are using the only tool at their disposal, interest rate cuts, in an effort to make sure that does not happen.

Fed officials fear that a renewed slump would cause unemployment to increase, business profits to fall and perhaps stock prices to slide further. They also want to make sure that economic weakness does not cause the overall level of prices of goods and services to decline, a condition known as deflation. If deflation were to take hold, it would be harder for consumers and businesses to repay their debts, which in turn could further depress the economy. Deflation also could reduce the ability of monetary policy to revive the economy, as it has in Japan.

"The data justify strong medicine," said economist Edward F. McKelvey of Goldman Sachs in New York. "The litany of weakness is impressive."

Consumer spending, adjusted for inflation, fell in September and probably stayed down in October, McKelvey said. Meanwhile, purchases of new equipment by businesses weakened in September and manufacturing activity appears to have declined in October for the third consecutive month, he said. "And the labor market is dead in the water.

"We are not alone in thinking that this amounts to a virtual stall . . . in the fourth quarter," McKelvey said. Goldman Sachs predicts that the economy will grow at only a 0.5 percent annual rate in the past three months of the year, and at only a 1.5 percent annual rate in the first three months of next year.

Over the past year, the nation's inflation-adjusted gross domestic product increased 3 percent, but that growth was not strong enough to put much of a dent in the unemployment created by last year's recession. The jobless rate edged up to 5.7 percent last month; payroll employment has fallen in the past two months.

The Fed's interest rate cuts should lower borrowing costs for consumers and businesses, but by how much is not clear. Major banks quickly began to reduce their prime lending rate by half a percentage point, to 4.25 percent, and many consumer and small-business loan rates are tied to the prime. In many cases, however, the rates on unpaid credit card balances and home-equity loans are already at the minimums set by the loan agreements. Furthermore, some executives of small companies have complained that banks have greatly tightened the terms for loans in ways unrelated to interest rates, such as reducing the size of credit lines and increasing requirements for collateral.

The impact on home mortgage rates is also unclear. Those rates, which track the ups and downs of yields on 10-year U.S. Treasury notes, have recently been at their lowest levels in decades. Analysts said the Fed's action is likely to cause yields on Treasury notes, and therefore mortgages, to drop lower than they otherwise would have been, but it was hard to predict by how much.

Still, the Fed's move will reduce what banks pay for money to lend, and they are likely to pass the savings to the larger, most creditworthy companies. Fed officials believe that some firms will be more willing and able to borrow more to finance new capital projects or additional inventory, both of which could boost economic growth.

Stock market investors weren't quite sure how to react to the Fed decision. Many of them had already factored a rate cut into their thinking, but were looking for only a quarter-point reduction rather than a half-point. In fact, some worried that a half-point reduction would be seen by some as a sign that the economy is even weaker than many believed. When the larger-than-expected cut was announced, the market jumped ahead and then steeply retreated before beginning a gradual ascent to close up modestly.

"Eventually the rate cut came to be seen as good news," said Bryan Piskorowski, a market analyst at Prudential Securities Inc.

In the statement issued after its meeting, the Federal Open Market Committee said last year's aggressive rate cuts and this year's strong gains in labor productivity are still stimulating the economy. "However, incoming economic data have tended to confirm that greater uncertainty, in part attributable to heightened geopolitical risks, is currently inhibiting spending, production, and employment," the statement said.

By "geopolitical risks," the committee meant the possibility of war with Iraq, a prospect that has left many business executives so uncertain about the economic outlook that they have become reluctant to hire more workers, increase production or invest in new plants, equipment and software. At the same time, consumer confidence and spending have slipped, and many forecasters expect the economy to grow very weakly in the final three months of this year.

Fed officials said their decision to cut rates "should prove helpful as the economy works its way through this current soft spot."

Sung Won Sohn, chief economist for Wells Fargo & Co., said the Fed acted because of concern over "the wobbly economy and the threat of deflation."

"A possible war against Iraq could further rattle the economy and the financial markets," he said, so "the central bank has taken out an insurance policy to support the economy."

Sohn said the Fed sought to have a greater impact on market psychology by cutting its target by half a point. At 1.25 percent, the new target is lower than most measures of inflation, a condition that usually provides significant stimulus to economic growth.

Fed officials and some economists have expressed uncertainty over how effective an action like yesterday's would be simply because they have no experience with a such a low rate. In July 1961, the last time the rate was so low, it was determined entirely by market forces and was not used as a tool of monetary policy by the central bank.

In an unmistakable signal that yesterday's move was not the beginning of a series of rate cuts, the Open Market Committee said it now regards the risks to its goals of price stability and sustainable economic growth as balanced.

"Unless further shocks hit the economy in coming months, 1.25 percent should be the low for this easing cycle," said Bruce Steinberg, chief economist at Merrill Lynch & Co. in New York. When the Fed began cutting rates in January 2001, the target was 6.5 percent. Eleven rate cuts reduced that to 1.75 percent by last December.