Fed slashes interest rates to buffer economy

By Mark Felsenthal

WASHINGTON (Reuters) - The Federal Reserve on Tuesday slashed U.S. interest rates by a hefty half-percentage point in a bold bid to shield the economy from a housing slump and financial turbulence, sparking a big rally on Wall Street.

The unanimous decision by the central bank's policy-makers took the benchmark federal funds rate, which governs overnight loans between banks, down to 4.75 percent, its lowest since May of last year. The Fed also cut the discount rate it charges for direct loans to banks by a half-point to 5.25 percent.

It was the first cut in the federal funds rate -- the Fed's main tool to influence the economy -- since June 2003 and the first half-point cut since November 2002.

Financial markets had widely expected the Fed to lower overnight borrowing costs, but were surprised by the aggressive half-point move, the first rate cut since Ben Bernanke took over as chairman of the central bank in February last year.

Stock prices surged as the decision gave investors hope the housing and credit turmoil wouldn't drag the economy down. The blue-chip Dow Jones industrial average closed up 335.97 points, or 2.51 percent, at 13,739.39. It was the Dow's best daily percentage gain since 2003.

However, prices for long-term government debt fell, suggesting some investors worried the Fed would fail to keep inflation tamped down, although prices for short-term notes rose in anticipation of further rate reductions.

"The Bernanke Fed has finally cast its unwarranted caution aside; we applaud this bold move," said Ian Shepherdson, chief U.S. economist at High Frequency Economics, in Valhalla, New York.

LIMITS TO RATE CUTS SEEN

But others worried the Fed may be prematurely abandoning its vigilance against inflation to soothe markets.

"This should make people less confident for the Fed to achieve their No. 1 objective, which is keeping inflation at bay," said Robert MacIntosh, chief economist at Eaton Vance Management, in Boston. "They overreacted."

Commercial banks swiftly followed the Fed and cut the prime rate they charge their best customers for loans.

Often when the Fed begins to lower credit costs, a heavy cycle of rate-cutting is in store. But economists on Wall Street appear to think the course kicked off by the Fed on Tuesday would prove limited.

A Reuters poll of 18 top bond firms that trade directly with the Fed in the markets showed a median forecast for a 4.5 percent federal funds rate by the time the central bank's easing cycle ends -- just a quarter-point below where the Fed left rates on Tuesday.

PRE-EMPTIVE STRIKE

In a statement outlining its decision, the Fed said its move was a pre-emptive strike to neutralize the impact of market turmoil on the economy.