Tuesday, January 22, 2008

US Fed makes biggest rate cut in 24 years by three quarters of a point

Fed slashes key rate to 3.5%

Citing weakening economic outlook, Federal Reserve makes biggest cut in nearly 24 years - three quarters of a point.

By Paul R. La Monica, CNNMoney.com editor at large

NEW YORK (CNNMoney.com) -- The Federal Reserve slashed two key interest rates by three-quarters of a percentage point Tuesday following an unscheduled meeting, citing continued concerns about a weakening economy and turmoil in the financial markets.

The Fed lowered its federal funds rate, which impacts how much consumers pay on credit card debt, home equity lines of credit and auto loans, to 3.5 percent from 4.25 percent.

The Fed also lowered its discount rate, which is what it costs banks to borrow directly from the central bank, by three-quarters of a point, to 4 percent.

This was the biggest rate cut by the Fed since October 1984. And it was the first cut between regularly scheduled meetings since a half-point cut on the day the market reopened following the September 2001 terrorist attacks.

"Broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets," the Fed said in a statement.

Treasury Secretary Henry Paulson, speaking at the U.S. Chamber of Commerce in Washington Tuesday morning, said that he hoped the rate cut would restore some confidence in the financial markets and U.S. economy.

"I think it's very constructive and what I think it shows to this country and to the rest of the world [is] that our central bank is nimble and able to move quickly to respond to market conditions and that should be a confidence builder," he said.

Investors didn't appear to share this sentiment though. Stocks plunged at the open Tuesday morning, following two straight days of massive selloffs abroad. But stocks bounced off their lows as the morning progressed.

"You can get into a debate as to whether we're in a recession or not, but it's a really turbulent period right now and that makes it difficult for investors to figure out what to do," said Phil Dow, director of equity strategy with RBC Dain Rauscher.

Dow said the rate cuts are a welcome sign that should eventually help to stabilize the markets but he cautioned that stocks, particularly beaten down financial services companies, could still see more pain ahead.

"Investors have to be careful about focusing on things that look cheap," Dow said.

Wall Street had been betting that the central bank would need to initiate an emergency rate cut before its next scheduled meeting, which concludes on Jan. 30, in an attempt to help keep the economy from tipping into a recession.

Since September, the Fed has cut the fed funds rate to 4.25 percent from 5.25 percent. Investors have been clamoring for more, and bigger, rate cuts hoping that it will kick-start a moribund economy and encourage businesses and consumers to spend.

And the Fed is still widely expected to cut rates again at its Jan. 30 meeting. According to futures listed on the Chicago Board of Trade, investors are pricing in a 92 percent chance that the Fed will lower the federal funds rate another half-point, to 3 percent, next week.

"This was a big step but there is still more to go. More rate cuts will be necessary," said Keith Hembre, chief economist with First American Funds. Hembre thinks that the Fed will cut the fed funds rate to at least 2.5 percent within the next few months.

The Fed has also loaned $70 billion to banks through a series of three auctions since December to help mitigate the effects of the credit crunch on Wall Street. That appears to be working as the Fed said Tuesday that "strains in short-term funding markets have eased somewhat."

President Bush and Congress are also working on an economic stimulus package in order to help beleaguered consumers. Federal Reserve chairman Ben Bernanke endorsed this plan during a speech to the House Budget Committee last week and urged Congress to act "quickly."

But markets have plunged so far in 2008 despite this as investors continue to fret that the Fed may be doing too little too late to keep the economy from recession.

At this point, Hembre said, it's probably too late for the Fed to prevent a recession since there tends to be a lag of several months before rate cuts begin to have an impact on the economy. But he said the emergency cut, combined with the three rate cuts in 2007, could help make a recession brief.

"This rate cut certainly leads to a better outlook in 2009, but it may not have any effect on the first quarter or even first half of this year. We could start to feel some benefit later in the year though," Hembre said.

Still others think the Fed needs to proceed cautiously, especially since it's fair to argue that aggressive rate cuts during 2001 may be the reason why banks are in the subprime mortgage mess they are in now.

To that end, William Poole, president of the Federal Reserve Bank of St. Louis, voted against the current rate cut. According to the Fed's statement, Poole did "not believe that current conditions justified policy action before the regularly scheduled meeting next week."

Fed board member Frederic Mishkin did not participate in the emergency meeting.

In addition, high prices of oil, gold and other commodities, coupled with a weak dollar, are a sign that inflation is not necessarily dead yet. One market strategist said he thinks the Fed made a mistake by cutting rates so drastically since it could lead to bigger inflation worries down the road.

"The Fed is sacrificing the U.S. dollar, which may well compound our problems in the future. I think the auctions are a more precise way to alleviate credit issues," said Haag Sherman, managing director of Salient Partners, an affiliate of investment firm Sanders Morris Harris. To top of page

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