Federal Reserve Cuts Rate to 1% to Avert Prolonged Recession

Oct. 29 (Bloomberg) — The Federal Reserve cut its benchmark interest rate by half a percentage point to 1 percent, matching a half-century low, in an effort to avert the worst U.S. economic downturn in the postwar era.

“Downside risks to growth remain,” the Federal Open Market Committee said today in a statement in Washington. “Recent policy actions, including today’s rate reduction, coordinated interest-rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth.”

Central bankers worldwide are trying to revive credit and stop a self-reinforcing downturn in consumer spending and bank lending from triggering a global recession. Today’s decision follows the half-point reduction the Fed coordinated with the European Central Bank and four other central banks on Oct. 8. Borrowing costs were pared today in Norway and China.

The U.S. economy shrank at a 0.5 percent annual rate last quarter, the most since the 2001 recession, the Commerce Department’s report on gross domestic product will probably show tomorrow. Economists expect the slump to persist in the fourth quarter, according to the median estimate.

`Economy Weakens’

“If the economy weakens further, it may open the door for another 25 or 50 basis points in December,” said John Silvia, chief economist at Wachovia Corp. in Charlotte, North Carolina.”

Plunging commodity prices, including a 54 decline in the cost of oil from a record in July, have eased inflation pressures.

“The committee expects inflation to moderate in coming quarters to levels consistent with price stability,” the FOMC said in today’s statement.

The vote was unanimous. The Fed also lowered the discount rate a half point to 1.25 percent.

While cutting the main rate during the past 13 months from 5.25 percent, Fed Chairman Ben S. Bernanke, 54, has created six loan programs channeling at least $700 billion in cash and collateral into money markets as of Oct. 22.

“This Federal Reserve has been extremely aggressive in terms of providing liquidity,” Frederic Mishkin, a former Fed governor and now a Columbia University professor, said in a Bloomberg Television interview before the announcement.

Confidence Weakens

Still, consumer confidence tumbled this month to a record low, and orders for durable goods, excluding automobiles and aircraft, dropped for a second straight month in September, reports showed this week. Home prices in 20 U.S. cities declined 16.6 percent in August from a year earlier as foreclosures climbed, according to the S&P/Case-Shiller home price index. The Standard & Poor’s 500 Stock Index is down 36 percent this year.

“The intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit,” the Fed’s statement said. “The pace of economic activity appears to have slowed markedly.”

The credit crisis that began in August 2007 with rising foreclosure rates has led to the collapse or forced mergers of some of Wall Street’s biggest firms. Lehman Brothers Holdings Inc. filed for bankruptcy last month, while the government seized control of American International Group Inc. and put Fannie Mae and Freddie Mac under conservatorship. Wachovia Corp. agreed this month to be acquired by Wells Fargo & Co.

Global financial institutions have reported $680 billion in writedowns and credit losses on home loans, mortgage-backed securities and related assets.

Funding Costs

The spread between the cost of overnight loans in New York and three-month dollar loans in London widened to 4.02 percent on Oct. 10 as investors fled risk following Lehman’s Sept. 15 bankruptcy. The spread averaged 0.27 percentage point for all of last year. It has since fallen back to 2.5 percentage points.

Bernanke and U.S. Treasury Secretary Henry Paulson gained congressional approval this month for the use of taxpayer funds for a $700 billion bank rescue. The Treasury plans to use some of the funds in the Troubled Asset Relief Program to buy equity stakes in banks.

The Fed redoubled its aid this month, agreeing to finance the commercial paper issuance of General Electric Co. and other corporations and help money-market mutual funds raise cash to meet shareholder redemptions.

Fed’s Balance Sheet

The central bank’s new loan programs have expanded assets on its balance sheet by 104 percent during the past year to $1.804 trillion, or 12.6 percent of GDP.

Borrowing costs have remained high. U.S. 30-year mortgage rates tracked by Freddie Mac were 6.04 percent last week versus 6.07 percent on Jan. 3. Banks are unlikely to compete for new loans and offer lower rates so long as the outlook for the economy is dim, economists said.

“We are in an environment where they lower rates, but then spreads widen so you get no net effect,” Vincent Reinhart, former director of the Fed Board’s Division of Monetary Affairs who is now a visiting scholar at the American Enterprise Institute in Washington, said before the decision. “We are in a recession.”

Fed officials provided their forecasts for this year and the subsequent three years at the two-day meeting. The uncertainties surrounding the Fed’s forecast are “unusually large,” and the economy may experience subpar growth “for several quarters,” Bernanke told the House Budget Committee on Oct. 20.

The economy “looks terrible,” Stephen Stanley, chief economist at RBS Greenwich Capital Markets Inc., said before the announcement. “Consumer spending is going to be very negative in the fourth quarter, even with gasoline prices falling.”

Policy Tools

Now that their target rate is so low, Fed officials may have discussed alternative policy strategies such as the possibility of keeping rates low on short- and medium-term notes. Bernanke, as a Fed governor, was the top central bank official on research into “non-traditional” policy tools between 2002 and 2004, when the central bank last cut the benchmark lending rate to 1 percent.

The Fed has lost some control over the amount of reserves in the banking system because the total lending in some of its programs are driven by market demand. As a result, the federal funds rate has traded below its target every day since the Oct. 8 emergency rate cut.

The central bank raised the floor on the benchmark lending rate and said on Oct. 22 that interest on excess reserves would be equal to the federal funds rate minus 0.35 percentage point. The previous floor was 0.75 percentage point below the federal funds rate. Still, the move hasn’t closed the gap between the target rate and the market rate.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net

Last Updated: October 29, 2008 14:57 EDT
By Craig Torres

Source: Bloomberg

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