Fed To The Rescue: Cuts Rate By A Quarter Point

The Federal Reserve cut a key interest rate by one-quarter of a percentage point Tuesday, but Wall Street took a tumble. Investors were disappointed that the central bank did not act more boldly to keep the country out of a recession.
The reduction in the federal funds rate to 4.25 percent marked the third rate cut in the past three months. Fed officials signaled that further cuts were possible if a severe housing downturn and mortgage lending crisis get worse.
But Wall Street was looking for a much stronger sign. The Dow Jones industrial average, which had been up about 40 points in afternoon trading, plunged by more than 200 points as investors deciphered the Fed's comments.
"They should have issued a statement that they were prepared to do what they needed to do to return the credit markets to more normal conditions and to protect the economy from the effects of the credit crisis," said David Jones, chief economist at DMJ Advisors.
David Wyss, chief economist at Standard & Poor's in New York, said he was still looking for three more rate cuts early next year, even though the language in the statement was not as forceful as some had expected.
Commercial banks quickly matched the Fed move by trimming their prime lending rate to 7.25 percent. That put the benchmark rate for millions of business and consumer loans at its lowest point in two years.
In addition to cutting the funds rate, the Fed announced it was reducing its discount rate, the interest it charges to make direct loans to banks, by a quarter-point as well to 4.75 percent. This reduction was aimed at encouraging banks to borrow more freely from the Fed at a time when there are worries that a rising number of bad loans will prompt banks to tighten credit conditions too severely, adding another strain on the already fragile economy.
The Fed embarked on this round of rate cuts in September in response to severe turbulence in credit markets around the globe as investors reacted to various reports of mounting losses from defaults in subprime mortgages, the latest fallout from the worst slump in the U.S. housing market in more than two decades.
After cutting the funds rate by a half-point on Sept. 11 and a quarter-point on Oct. 31, the central bank indicated that those two reductions might be all that were needed to combat the threat of a recession given that financial markets appeared to be stabilizing.
However, increased market turbulence following the October meeting and growing fears of a recession caused the Fed to do an about-face.
In a brief statement explaining its action, the Fed said that recent economic data indicated that the economy is slowing, "reflecting the intensification of the housing correction and some softening in business and consumer spending."
The Fed also noted that "strains in financial markets have increased in recent weeks."
In its Oct. 31 statement, the Fed said it viewed the risks from weak growth as roughly balanced with the risks of higher inflation.
However, that phrase was changed in the current statement to read, "Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation."
The Fed vote for the rate cut was 9 to 1 with Eric S. Rosengren dissenting, arguing for a bigger, half-point cut in the funds rate.
Many economists believe the housing slump and credit turmoil have raised the risks of a recession. Many analysts believe that economic growth, as measured by the gross domestic product, may have dipped to a barely perceptible 1 percent rate, raising the chance that some shock, such as another surge in energy prices, could push the country into a recession.
But many analysts still believe the Fed will be able to respond forcefully enough with rate cuts that it will keep the current expansion alive. These analysts believe that the economy will start to rebound to faster growth by the middle of next year, when they expect that lower mortgage rates will have spurred a rebound in home sales.