updated 8/16/2007 8:08:50 AM ET 2007-08-16T12:08:50

The Federal Reserve added billions more to the banking system Wednesday in a fight to keep a credit crisis from derailing the economy. Speculation is growing that the Fed also will cut interest rates, perhaps as soon as next month.

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The Fed has not lowered rates in more than four years. But many economists, while watching another wild day on Wall Street, said they believe the central bank would do just that in the weeks ahead if the market turmoil becomes severe enough.

The Dow Jones industrial average fell 167.45 points Wednesday to close at 12,861.47. It was the Dow’s first close below 13,000 since April 24 and left the blue-chip index down more than 8 percent from its record close of 14,000.41 reached July 19.

“With financial markets in disarray and the potential for a credit crunch, the Fed will have little choice but to ease policy,” said Mark Zandi, chief economist at Moody’s Economy.com.

By pumping an additional $7 billion into the banking system, the Fed sought to keep the federal funds rate, the interest that banks charge each other, from rising above the Fed’s current target of 5.25 percent.

Since Aug. 9, the Fed has injected $71 billion into the banking system. The rescue effort was triggered by the shock waves when BNP Paribas, France’s largest bank, froze three funds that had invested in the troubled U.S. mortgage market.

A 387-point plunge that day followed the developments in France as investors worried that many more troubled investment funds and bad debt would come to light.

The $38 billion boost from the Fed last Friday was the largest one-day cash infusion since the attacks of Sept. 11, 2001. But to many analysts, the current situation is more similar to the 1997-98 global financial crisis, which began in Thailand and eventually pushed 40 percent of the worldwide economy into recession.

In August 1998, Russia became the latest victim, devaluing its currency and defaulting on part of its foreign debt. That led to a severe credit crunch that toppled a giant U.S. hedge fund, Long Term Capital Management, and sent panic through U.S. credit markets. The result was a virtual halt in trading of many debt instruments.

Then-Fed Chairman Alan Greenspan and his colleagues pushed ahead with a series of one-quarter percentage point rate cuts in the fall of 1998. The moves were enough to get financial markets working again and keep the U.S. economy from recession.

While the current situation has not become as dire, analysts said it could quickly develop into a full-blown credit crisis if there are more announcements in coming days of serious credit problems in major hedge funds or banks, problems that had their start in rising defaults in the market for subprime mortgages, loans extended to borrowers with weak credit histories.

“This is a day to day proposition. The credit markets are still walking on egg shells. Almost every day we get another bad announcement,” said David Jones, head of DMJ Advisors, a Colorado-based consulting firm.

The current market volatility represents the first big test for Fed Chairman Ben Bernanke, who took over in February 2006 when Greenspan stepped down after 18½ years at the helm of the Fed.

The scholarly Bernanke, who came to the Fed after spending most of his career teaching monetary policy at Princeton University, is being watched closely to see whether he has the street smarts that Greenspan exhibited in knowing how to read and communicate with financial markets.

Part of the challenge is that Bernanke’s Fed has been insisting that its biggest worry is not the slowdown in the economy that has been occurring because of the worst slide in housing in 16 years, but the threat that inflation pressures will not ease.

Even last week, the Fed said after its Aug. 7 meeting when it left interest rates unchanged that its “predominant policy concern” remained the risk that inflation would not moderate as expected.

The Fed did get good news on inflation this week with the Labor Department reporting Wednesday that consumer inflation edged up a tiny 0.1 percent in July, the smallest increase in eight months, as gasoline prices fell.

In its statement last week, the central bank did acknowledge the downside risks to the economy had “increased somewhat” with volatile financial markets, credit conditions tightening and the housing market correction continuing.

Analysts saw those comments, in light of the increased market turbulence since the Fed meeting, as boosting the chance that the central bank will cut rates later this year.

That is certainly the prevalent view among investors placing bets in the federal funds futures market, where the prospect of Fed rate cuts has risen from almost nonexistent a few weeks ago to now a high probability of three quarter-point cuts before the end of this year.

Some analysts said unless conditions in financial markets get much more severe Bernanke and other Fed officials will wait to cut rates after they see more information pointing to an economic slowdown.

“The Fed does not want to be seen as bailing out financial markets for their bad investment decisions,” said Lyle Gramley, a former Fed board member and now a senior adviser at the Schwab Washington Research Group.

Gramley, however, said he believed incoming data would show a serious enough impact on the overall economy from the slump in housing and the credit troubles that the Fed will be ready to cut rates by a quarter-point at both its October meeting and in December at its final meeting of the year.

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