September 18, 2007 / 6:40 PM / 12 years ago

Fed slashes interest rates to buffer economy

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.

Clerks relay trades in the Euro Dollar pit at the Chicago Mercantile Exchange after the Federal Reserve slashed interest rates by a half-percentage point, September 18, 2007. REUTERS/John Gress

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.


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.


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.

“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,” it said.

The central bank said it still believed the economy faced some risk of inflation, but said market developments since its last meeting in early August had increased the uncertainty surrounding the 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,” it said.

There has been accumulating evidence that a prolonged U.S. housing market downturn and a wild financial market ride over the summer have taken a toll on broader economic activity.

A decline in employment in August, the first drop in four years, appeared to confirm that housing-related strains were weighing on businesses and households.

In addition, reports on retail sales and industrial output in August also showed some softness.

At its previous regular meeting on August 7, the U.S. central bank had said its predominant concern was inflation, even as it noted tighter credit and financial market volatility.

Within days, financial markets unraveled as French bank BNP Paribas froze three funds with U.S. subprime mortgage market exposure. The Fed on August 10 said it would pump cash into the banking system as needed to keep markets functioning normally.

Even so, stock markets tumbled the following week, at one point plumbing declines of more than 10 percent below 52-week highs before rebounding.

Slideshow (5 Images)

The Fed then stepped in on August 17 with a surprise cut to the discount rate and an explicit acknowledgment that risks to economic growth had “increased appreciably.”

Tuesday’s rate cut seeks to address those risks.

“I think it was the right move,” said Martin Feldstein, head of the National Bureau of Economic Research, who had called for rate cuts. “It can’t solve the problems that are weakening the economy (but) it can help offset them.”

Additional reporting by David Lawder and Emily Kaiser in Washington and Tamawa Kadoya in New York

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