Citing a weak economy and the threat of war, the Federal Reserve flexed its monetary muscle Wednesday and cut interest rates by one-half of 1 percent–twice what many observers had expected.
The size of its first interest-rate reduction this year reflected the Fed’s concern over the economy’s sluggish performance. Chairman Alan Greenspan’s central bank is taking no chances that a devastating period of deflation, or falling prices, could take hold in the U.S., as it has in Japan.
The Fed voted unanimously to lower its benchmark overnight bank lending rate to 1.25 percent. By cutting rates, it hopes to spur more consumer spending and business investment. Investment spending is a key to job creation and economic growth, but it has been stagnant for two years.
Several analysts said the bold move would help the economy recover by cutting borrowing costs, especially for businesses that have complained that banks are charging too much. But others said lower interest rates might fail to provide the necessary lift to pull the economy out of the doldrums.
Wall Street, already happy about Republican victories in Tuesday’s congressional elections, bounced up, then down, and then back up again in a cautionary response to the Fed’s move. At the end of the day, the blue-chip Dow Jones industrial average was 92.74 points higher.
David Wyss, chief economist at Standard & Poor’s Corp., said the central bank took a strong, unanticipated step in tackling economic weakness and helped ease concerns of a double-dip recession.
“I think the Fed decided there is no point in saving your bullets until you are dead,” he said.
Still, there was an undercurrent of concern that the central bank might be showing a bit of panic in attacking the economy’s slow growth so aggressively.
“What does the Fed know that we don’t know?” asked mortgage broker Jim Warns, of Oakton, Va.
Uncertainty limits growth
In its statement, the central bank’s policy-making arm, the Federal Open Market Committee, said its current regime of low interest rates is supporting economic growth. But it added that “greater uncertainty, in part attributable to heightened geopolitical risks, is currently inhibiting spending, production and employment.”
The lower interest rates “should prove helpful as the economy works its way through this current soft spot,” the Fed policymakers said.
The Fed also shifted its view of the economy slightly, saying that it will give economic weakness and inflation equal weight in deciding future monetary policy. Recently, the Fed has been more concerned about economic weakness.
The switch to a “neutral bias” appeared to mean the central bank will wait a while to determine whether its latest rate cut actually revives the economy. If it doesn’t, analysts said, another cut is in the offing.
According to economists, there is no sign of inflation. In fact, deflation is seen as a bigger threat. By citing inflation as a risk, analysts said, the central bank signaled that it would raise interest rates if it sees the economic recovery strengthening.
Wednesday’s rate cut will reduce borrowing costs across the economy, particularly interest costs on home-equity and other consumer loans. Many analysts predicted that the cut also will reduce mortgage interest rates, though others said the move could cause long-term interest rates to rise if the Fed action is perceived as strengthening the economy.
For the elderly who depend on interest income from certificates of deposit and money-market mutual funds, the Fed’s action will hurt, said Sung Won Sohn, chief economist at Wells Fargo Bank.
“There isn’t much they can do,” he said. “If they try to get higher rates [in the bond market], there are increased risks.”
In fact, some money-market mutual funds have seen the returns paid to investors drop so low that they are struggling to cover business costs, said Michael Drury, chief economist at McVean Trading Co. of Memphis.
Nonetheless, Drury said, when combined with the Republican election victory, which offers hope for tax cuts, the Fed’s half-point reduction gives the economy “about as much juice as you can get.”
Commercial banks’ prime lending rate, a key rate for many borrowers, is expected to be reduced across the economy to 4.25 percent–the lowest since May 1959. Some banks announced the reduction Wednesday, and others are expected to follow suit.
“If the Fed is going to cut interest rates, it might as well be aggressive,” said William Wilson, economist at Ernst & Young in Chicago. If the central bank had decreased interest rates by only one-quarter of 1 percent, as had been widely predicted, the economic impact would have been much smaller.
Jay Mueller, director of fixed income at Strong Capital Management in Menomonee Falls, Wis., said he saw no need for an interest rate cut now. In his view, the Fed waited too long and should have moved in August, when the economy was struggling.
Other rates tied to fed funds
The Federal Reserve influences the level of interest rates throughout the economy by raising or lowering the so-called federal funds rate, which banks charge each other for overnight loans. Other short-term rates are tied to this rate, which the Fed lowers by using its power to pump more money into the economy.
Inside the Fed, there has been concern that a mild form of deflation, in which falling prices cause consumers to pull back on spending, could be on the horizon in the U.S. But analysts such as Mueller and Wilson said the odds of 1930s-style deflation are extremely low.
The central bank’s hefty rate cut was a sign that the Fed is taking no chances on the deflation threat, however small it may be.
The central bank has little room to reduce interest rates further. Japan has cut its interest rates to zero in an effort to stave off a strong deflationary cycle. The Fed could do the same thing in the U.S. if necessary.
