The Federal Reserve Wednesday cut interest rates for the second time in six weeks signifying that the central bankers — for the moment — are more concerned with the recent turmoil in the financial markets and possible weakness in the economy than with fighting inflation.
Despite a report showing stronger-than-expected economic growth in the third quarter, the Fed cut the benchmark overnight rate a quarter-point to 4.5 percent, and made a similar quarter-point cut in the less-important discount rate. The move had been widely anticipated by financial markets, as futures traders had placed bets on a quarter-point cut.
“If it weren’t for those market expectations, I don’t think the Fed would be cutting,” said Alan Blinder, a Princeton Univeristy economist and former Fed vice chairman.
Wall Street applauded the move, with the Dow Jones industrial average rising more than 137 points, or about 1 percent.
In its statement accompanying the vote, the Fed said that it now thinks the risks of recession and higher inflation are in “balance” — a signal that the Federal Open Market Committee is less likely to make another cut down the road. To emphasize the point, the FOMC highlighted concerns about higher oil and other commodity prices and said the central bank would “continue to monitor inflation developments carefully.”
The careful choice of words was seen by some as a sign that the central bank is trying to avoid the impression that its policy decision placed the interests of the finacial markets ahead of the its broader mandate to promote economic growth and stable prices.
"They get trapped into having to do what the market wants,” said Robert McTeer, a fellow at the National Center for Policy Analysis and a former head of the Dallas Fed. “I believe this was a little bit of a declaration of independence.”
The decision to cut both the federal funds rate, which banks pay each other for short-term loans, and the discount rate on direct borrowing from the central bank will help cut borrowing costs for businesses and consumers on a wide range of loans including home equity credit lines and some credit cards. Commercial banks immediately lowered their prime rate a quarter-point to 7.5 percent. The cut could also indirectly ease rates on longer-term rates like home mortgages.
The case for making the cut was far from clear. After a surprise half-point cut last month to quell turmoil in the credit markets, the Fed faced a difficult choice Wednesday heading into the second day of rate-setting deliberations.
Investors have been betting on a cut largely because of ongoing bad news from the housing market, as both the pace of building and home prices continue to decline. Though the credit markets have settled somewhat — since all but shutting down briefly in August — recent reports of big mortgage-related losses on Wall Street have left lenders and investors nervous about the possibility of future losses. Foreclosure rates are expected to continue to rise, especially among borrowers who hold mortgages with low “teaser” rates that are set to jump next year.
So far, the recession in the housing industry doesn’t seem to have spilled over to the broader economy. On Wednesday the Commerce Department reported that its first estimate of economic growth for the third quarter showed that U.S. gross domestic product advanced by a healthy 3.9 percent rate, faster than most economists had expected.
But central bankers focus on what lies ahead. And economists say the outlook for next year is unclear.
“Expectations are that the holiday season will be relatively flat,” said John Lonski, chief economist at Moody’s Investor Service. “And as we look ahead, we don’t have a strong reason to believe that hiring activity will be strong enough to offset the weakness from possibly lower home prices.”
Lyle Gramley, a former Fed board member and now an economist with Stanford Financial Group, put the chances of a recession at around 40 percent, saying the Fed’s primary concern right now is what is happening in housing and how much of a spillover that will have on the overall economy.
“It is possible that the housing industry will take us over the edge into a recession,” he said, noting that every housing downturn of the past 60 years with the exception of two have triggered recessions.
Other crosscurrents have made the Fed’s job tougher. A weaker dollar, for example, has given U.S. companies a shot in the arm, boosting exports and increasing profits made from overseas operations when that money is brought back home. But a continued slide in the U.S. currency could put added upward pressure on long-term interest rates, as foreign investors demand higher returns to buy Treasury debt that’s backed by a falling currency.
Cutting rates also risks easing up on the Fed’s perennial battle against inflation. The latest GDP report showed prices rising at an annual rate of 1.8 percent in the third quarter – up from the 1.4 percent rate in the second quarter but still within the Fed’s unofficial “comfort zone.” But the recent surge in oil prices — which the Fed highlighted in its commentary — could begin to put pressure on the price of other products.
Higher food prices are also a concern. One Wednesday, Kraft Foods reported that profits in the latest quarter were been squeezed by higher dairy prices. Though companies facing higher raw materials prices can absorb them for awhile, a prolonged rise in producer prices eventually gets passed along to consumers.
The Fed had pushed the federal funds rate up a record 17 consecutive times in quarter-point moves over two years. The last increase occurred in June 2006. From that time until last month, the rate was left unchanged as the central bank watched to see whether its credit tightening had the desired effect of slowing the economy enough to lessen inflation pressures.
However, the Fed’s goal of a soft-landing in which growth slows and inflation is contained has been threatened by the most severe housing downturn in more than two decades. Economists are worried that the credit crisis this summer will make home sales and prices fall even further, threatening consumer confidence and causing consumers to cut back on their spending.
Full text of Fed statement
The full text of the Fed's statement is below:
The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/2 percent.
Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.
Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.
The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; Eric S. Rosengren; and Kevin M. Warsh. Voting against was Thomas M. Hoenig, who preferred no change in the federal funds rate at this meeting.
In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 5 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Richmond, Atlanta, Chicago, St. Louis, and San Francisco.