The Federal Reserve jolted financial markets Wednesday, cutting short-term interest rates by a half-percentage point in an aggressive attempt to kick-start the stalled economy. In cutting rates for the first time in 11 months, Fed Chairman Alan Greenspan and his colleagues acknowledged that the economy has run into a “soft spot” after a surge in activity earlier this year.
Most financial analysts and traders had expected only a quarter-point cut, perhaps to be followed by another quarter-point in December or early in 2003. But Fed policy-makers decided instead on a single half-point cut and signaled they do not intend to cut rates any further for fear of triggering inflationary growth.
“What they’ve effectively done is two moves in one meeting,” said Ethan Harris, a chief economist at Lehman Bros.
It was the Fed’s first action on rates since Dec. 11, 2001, when the central bank concluded an extraordinary series of 11 rate cuts in 11 months that brought short-term rates to their lowest levels since the early 1960s. That rate-cutting campaign failed to prevent the U.S. economy from falling into its first recession in a decade, and now Fed officials have concluded it was not sufficient to guarantee a sustained recovery.
“Incoming economic data have tended to confirm that greater uncertainty, in part attributable to heightened geopolitical risks, is currently inhibiting spending, production, and employment,” the Fed’s Open Market Committee said in a statement explaining the move. With inflation well under control, “the Committee believes that today’s additional monetary easing should prove helpful as the economy works its way through this current soft spot.”
Focus shifting to Congress
The Fed’s action, lowering the benchmark federal funds rate to 1.25 percent from 1.75 percent, will mean lower rates on many consumer and business loans. Leading banks were expected to quickly lower the prime rate a half-point, or 50 basis points, to 4.25 percent, reducing rates for a wide range of of adjustable-rate loans tied to the prime.
Long-term mortgage rates, also at historically low levels, are unlikely to see much of an impact, analysts said.
But with short-term rates already at levels unseen since 1962, the psychological impact of Wednesday’s action is likely to be nearly as important as the actual impact on the economy.
“It should be reassuring,” said James Glassman, senior economist at J.P. Morgan Chase. “Now you don’t have to sit and wonder if you’re going to get another 25 basis points.”
He also said the move takes the Fed out of the picture for now and puts the economic focus squarely on Congress, which is expected to move aggressively to boost the flagging economy, perhaps through a new round of tax cuts, now that Republicans control both the House and Senate.
Stock prices ended with sharp gains after a seesaw session as investors digested the news. Stocks have risen sharply in recent weeks, boosted in part by expectations the central bank would begin easing rates again to prevent another economic downturn.
The economy has slowed in recent months as a wave of corporate governance scandals and the possibility of war in Iraq have made businesses reluctant to invest in equipment and create new jobs. Now fears are rising that consumers, who have propped up the economy, will curtail spending sharply in the upcoming holiday retail season.
Among the worrisome signs: The economy has lost jobs for two months in a row, industrial production has been declining and consumer confidence has plummeted. Although the economy grew at a respectable 3.1 percent rate in the third quarter, analysts expect anemic growth — possibly less than 1 percent — in the current quarter.
“I think the economy is going to grow quite nicely at some point next year,” said Harris of Lehman Bros. But he said the Fed will have to lower rates another quarter-point, probably in late January.
In a statement, the Fed’s Open Market Committee appeared to try to quell such speculation, saying the “the risks are balanced” between higher inflation and an economic slowdown. That was a change from its previous position that the risks of a slowdown outweighed any risk of renewed inflation.
While the shift appeared to rule out any further rate cut at the committee’s next meeting Dec. 10, the panelists might have to take a fresh look next year if the holiday retail season is poor, analysts said.
The Fed said the committee’s latest decision was unanimous, after the panel left rates unchanged in September over the objections of two members who favored lower rates.
The Fed Wednesday also cut the lesser-used discount rate from 1.25 percent to 0.75 percent, the lowest rate in at least 47 years, according to Fed records. The last time the federal funds rate touched 1.25 percent or below was in 1962.
Fed's full statement
The Fed issued the following statement regarding its decision to cut rates:
“The Federal Open Market Committee decided today to lower its target for the federal funds rate by 50 basis points to 1 1/4 percent. In a related action, the Board of Governors approved a 50 basis point reduction in the discount rate to 3/4 percent.
The Committee continues to believe that an accommodative stance of monetary policy, coupled with still-robust underlying growth in productivity, is providing important ongoing support to economic activity. However, incoming economic data have tended to confirm that greater uncertainty, in part attributable to heightened geopolitical risks, is currently inhibiting spending, production, and employment. Inflation and inflation expectations remain well contained.
In these circumstances, the Committee believes that today’s additional monetary easing should prove helpful as the economy works its way through this current soft spot. With this action, the Committee believes that, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are balanced with respect to the prospects for both goals in the foreseeable future.
Voting for the FOMC monetary policy action were Alan Greenspan, Chairman; William J. McDonough, Vice Chairman; Ben S. Bernanke, Susan S. Bies; Roger W. Ferguson, Jr.; Edward M. Gramlich; Jerry L. Jordan; Donald L. Kohn, Robert D. McTeer, Jr.; Mark W. Olson; Anthony M. Santomero, and Gary H. Stern.
In taking the discount rate action, the Federal Reserve Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Dallas and New York.”