The Federal Reserve unexpectedly slashed a key interest rate by a bold three-fourths of a percentage point on Tuesday, responding to a global plunge in stock markets that heightened concerns about a recession. The Fed signaled that further rate cuts were likely.
The reduction in the federal funds rate from 4.25 percent down to 3.5 percent marked the biggest reduction in this target rate for overnight loans on records going back to 1990. It marked the first time that the Fed has changed the funds rate between meetings since 2001, when the central bank was battling the combined impacts of a recession and the terrorist attacks.
Federal Reserve Chairman Ben Bernanke and his colleagues approved the large rate cut after an emergency video conference on Monday night, a day when global markets had been pounded by rising concerns that weakness in the world’s largest economy was spreading worldwide.
Despite the Fed’s bold move, Wall Street plunged at the opening with the Dow Jones industrial average down 465 points before stocks began to rebound. The Dow finished the day off 128.11 points at 11,971.19, according to preliminary calculations. Analysts said the milder decline at the end of the day after such a rough start showed the Fed’s effort to reassure Wall Street had an impact.
In a brief statement explaining its move, the Fed said that “appreciable downside risks to growth remain” and officials pledged to “act in a timely manner” to deal with the risks facing the economy. The action was approved on an 8-1 vote.
Analysts said the fact that the Fed did not wait until its meeting next week to cut rates underscored the seriousness of the situation.
“The world’s stock markets are in meltdown so the Fed came in with an inter-meeting move to try to stop the panic,” said Christopher Rupkey, senior economist at Bank of Tokyo-Mitsubishi.
The Bush administration, which had announced on Friday that President Bush supported a $150 billion economic stimulus package, said Tuesday that it was not ruling out doing more than the $150 billion proposal if necessary. Bush and Treasury Secretary Henry Paulson were conferring with congressional leaders at the White House on Tuesday, with all sides saying they want to reach agreement quickly.
The Fed was expected to cut rates further, possibly as soon as their next meeting on Jan. 29-30, if there are continued signs that the economy is weakening.
“This move by the Fed was essential,” said Lyle Gramley, a former Fed governor who is now a senior analyst with the Stanford Financial Group in Washington. “Bernanke promised in a speech earlier this month to take substantive action in a timely and decisive manner.”
Gramley said that Bernanke was now exercising the kind of forceful leadership the markets had been hoping to see since the credit crisis hit in August.
David Jones, chief economist at DMJ Advisors, said Fed officials have a range of options available at next week’s meeting from a quarter-point move to a half-point move to holding rates steady but indicating the Fed is prepared to move again between meetings should conditions deteriorate further. Jones predicted the Fed would lower the funds rate to 3 percent by the end of March.
In addition to cutting the funds rate, the Fed said it was reducing its discount rate, the interest it charges to make direct loans to banks, by a similar three-quarters of a percentage point, pushing this rate down to 4 percent.
Commercial banks responded to the Fed’s action on the funds rate by announcing similar cuts of three-quarter of a percent on its prime lending rate, the benchmark for millions of business and consumer loans. The action will mean the prime lending rate will drop from 7.25 percent down to 6.50 percent.
Global financial markets had plunged Monday as investors grew more concerned about the possibility that the United States, the world’s largest economy, could be headed into a recession. Many markets suffered their biggest declines since the September 2001 terrorist attacks.
In its statement, the Fed said it had decided to cut the federal funds rate “in view of a weakening of the economic outlook and increasing downside risks to growth.”
The central bank said that the strains in short-term credit markets have eased a bit, but “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.”
Before Tuesday’s move, the Fed had cut interest rates three times, beginning in September, the month after a severe credit crunch had roiled Wall Street and global financial markets. The Fed cut the funds rate by a half-point in September and then by smaller quarter-point moves in October and December.
“The committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risk,” the Fed statement said.
The Fed’s action was approved on an 8-1 vote with William Poole, president of the Fed’s regional bank, dissenting. The statement said that Poole objected because he did not believe current conditions justified a rate move before the Fed’s meeting next week.