Fed slashes key interest rate a 2nd time

1/31/2008

WASHINGTON - The Federal Reserve cut a key interest rate yesterday for the second time in barely a week, as its leaders concluded that the distress in financial markets is a sufficiently grave threat to ordinary Americans to warrant the most aggressive campaign of rate cuts in the modern history of the central bank.

It came amid new evidence that the crisis that began in complicated global markets for debt has now affected U.S. households. The nation experienced its weakest rate of growth since 2002 in the final three months of the year, the government reported yesterday.

The Fed cut the short-term interest rate it controls by half a percentage point, to 3 percent, on top of a three-quarter percentage point cut on Jan. 22. In the 19 years the Fed has explicitly targeted that interest rate, it had never cut it by that much in a single month.

The rate cuts should make it cheaper for Americans to borrow money through credit cards or to buy an automobile, and make it easier for businesses to borrow money to expand. It will likely lead to lower rates on many adjustable rate mortgages.

The twin moves were meant to prevent the slowdown from becoming a prolonged, crippling recession. The stock market initially soared on the announcement before ending the day down modestly.

"The Fed is buying an insurance policy against a deep recession," said Arun Raha, a senior economist with Swiss Re.

The strategy runs the risk, however, of limiting the Fed's options down the road if the slump worsens, and could spark inflation.

As the financial crisis that began in the market for U.S. mortgage loans spread in the fall, the Fed cut interest rates at a measured, steady pace - in line with past practice when the economy is threatened, such as during the 2001 dot-com bust, after the terrorist attacks that year, or during the savings and loan crisis in 1990.

But beginning in late December, data started to show a rapidly worsening economy, and Fed leaders concluded they needed to get ahead of the sense of crisis that was developing.

"This is really sharp and really dramatic," said Neal Soss, chief economist at Credit Suisse. "It reflects a sense that when a threat to the economy comes from the financial system, you need shock therapy. Small doses of medicine are not effective."

One risk to this approach is that if it doesn't work - if the economy slows significantly anyway - it could undermine the Fed's credibility, and that having already lowered interest rates significantly it would not have much further to cut.

Yesterday's statement of the Federal Open Market Committee indicated modest concern about inflation, indicating that Fed policymakers anticipate it to moderate - which would be expected if growth remains weak, as most analysts expect.

Some Fed policymakers appear to remain deeply worried about inflation.

Richard Fisher, president of the Federal Reserve Bank of Dallas, dissented from the decision, preferring not to cut rates.

This was the third straight policymaking meeting at which someone dissented from the decision.

Dissents were rare when Alan Greenspan was chairman of the central bank, especially in moments of crisis.

Current chairman Ben Bernanke has fostered more open deliberation on the Federal Open Market Committee, which makes rate decisions, but a side effect of that openness is that the committee can appear less unified.

The committee's statement appeared not to offer a strong indication of what it will do at its next meeting, March 18.

But it also used language, echoing its statement last week, that suggested that further rate cuts are a possibility.