The Federal Reserve Tuesday surprised financial markets with an aggressive half-point cut in a key lending rate, lowering borrowing costs for businesses and consumers in response to a housing downturn that threatens to spread to the broader economy.
"Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time," the Fed said in a statement. The central bank cautioned that "the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally."
While a rate cut had been widely expected, the aggressive half-point move surprised analysts and delighted investors, who had been uncertain in how Fed Chairman Ben Bernanke would respond to the first major economic crisis of his tenure. The stock market soared immediately after the announcement, with the Dow Jones industrial average jumping more than 200 points in the initial minutes.
It was the first time in more than four years that the central bank cut the main federal funds rate, which had been unchanged since a long series of rate hikes that ended in June 2006. The fed funds rate, which is what banks pay to borrow money overnight, now stands at 4.75 percent, down from 5.25.
Most economists predicted that Bernanke and his colleagues would choose to reduce the federal funds rate only by a quarter-point although a minority correctly predicted the bolder half-point move. But analysts agreed that the Fed's unanimous move Tuesday is unlikely to be the last word on the subject.
Many economists are predicting a string of three or more rate cuts as the central bank works to calm financial markets and keep the worst slump in housing in 16 years from pushing the country into a recession.
“We have a very soft economy, and if the Fed doesn’t lower rates then the economy could fall into a recession,” said Mark Zandi, chief economist at Moody's Economy.com.
Zandi has trimmed his forecast to show economic growth of about 2.5 percent in the current quarter, down sharply from 4 percent in the April-June quarter. He said the fourth quarter is likely to be even weaker at around 1.5 percent.
Analysts believe the Fed has room to cut rates because inflation pressures have been easing. In good news on that front, the Labor Department reported Tuesday that wholesale prices fell by 1.4 percent in August. It was the biggest drop in 10 months and much larger than the 0.3 percent fall that had been expected.
The slump in housing that began last year has sent delinquencies on subprime mortgages, loans make to people with weak credit histories, soaring to record levels. The rising delinquencies and foreclosures have caused a serious credit crunch as investors have grown worried about other types of loans, a development that has roiled global financial markets.
All this turmoil has forced a radical about-face at the Fed since its last meeting Aug. 7. At that time, the Fed left the funds rate unchanged and declared that its predominant concern was still that inflation would fail to moderate as expected.
But as conditions in financial markets grew more turbulent, the Fed began aggressively pumping extra cash into the banking system and on Aug. 17 announced a surprise half-point cut in its discount rate, the interest that it charges to make direct loans to banks. The Fed lowered the discount rate another half-point Tuesday.
Private forecasters say the Fed's worries are not misplaced, given that all but two of the housing downturns that have occurred since the end of World War II have been accompanied by recessions.
“You get as big a decline in housing as we are looking at and that is serious business,” said Lyle Gramley, a former Fed governor and now an analyst at Stanford Financial Group in Washington. “I think we will escape a recession, but just by the skin of our teeth.”
In one jarring note, employment fell in August by 4,000, the first outright decline in four years, with manufacturing and construction leading the job losses.
But economists said they believed that Bernanke, who wrote extensively as an economics professor on the Great Depression that followed the 1929 stock market crash, understands what needs to be done to avert downturns.
While some have complained that Bernanke has been more tentative than Greenspan would have been, no less an authority than his predecessor Alan Greenspan disagrees.
In a round of interviews to promote his new book, Greenspan, who was Fed chairman for 18½ years, said Bernanke was “doing an excellent job” and he doubted that he would have done anything differently.
Greenspan told The Associated Press that the odds of a recession have grown since earlier this year, even though “the economy is not doing badly at this stage.”
He put the odds of a recession at greater than one in three. “But best I can judge it is less than 50 percent,” he said.
Full text of Fed statement
The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 4-3/4 percent.
Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.
Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.
Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these 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; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; Eric Rosengren; and Kevin M. Warsh.
In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 5-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, St. Louis, Minneapolis, Kansas City, and San Francisco.
The Associated Press contributed to this report.