TOPICS > Economy

Fed Cuts Key Interest Rate in Latest Bold Move

March 18, 2008 at 6:10 PM EDT
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As fears of a recession intensified, the Federal Reserve cut the federal funds rate 0.75 percent Tuesday. A finance journalist from the Wall Street Journal discusses the rate cut and the markets' response.

JIM LEHRER: The Federal Reserve acts again. Ray Suarez has our update.

RAY SUAREZ: Today saw yet another aggressive move by the central bank to combat the credit crisis threatening the U.S. economy. Chairman Ben Bernanke and his colleagues on the Federal Open Market Committee have now cut the federal funds rate six times since September.

The U.S. markets responded to that and other economic news. Not only did the Dow Jones gain more than 400 points, but the broader Standard and Poor’s Index had its biggest daily percentage gain in five years.

Here to tell us more is Greg Ip of the Wall Street Journal.

And, Greg, the market was widely expecting a full-point cut when trading began today.

GREG IP, Wall Street Journal: Yes.

RAY SUAREZ: It got three-quarters. Is that still considered a significant event?

GREG IP: Oh, certainly, Ray. I mean, let’s put this in perspective. This only the second time in 14 years that they have cut by 0.75 of a percentage point. The first time was in January. They have now cut by 3 percentage points just since September.

That’s a pace of monetary easing which is even more rapid than what they did in 2001, which at the time was one of the most rapid on record.

And it tells us two things, Ray. It tells us, first of all, that the Fed sees considerable risks to the economy. There is essentially a risk of an adverse feedback loop here, where the economy gets weaker, which causes more loan losses, which causes banks to tighten up their lending, which makes the economy weaker again.

The second thing it tells us is that the Fed is prepared to act very aggressively against those risks, even as they have their eye at the other side on the problem of inflation.

Market reaction

RAY SUAREZ: As you mentioned, this was a pretty gloomy report. The Federal Open Market Committee said, "Recent information indicates that the outlook for economic activity has weakened further." But the market went up 420 points on the news. Why?

GREG IP: Well, the market didn't actually go up 400 points because the Fed cut rates. It went up 400 points in spite of the fact the Fed cut rates, because as we were discussing the cut was smaller than they actually expected.

The market went up because of other things the Fed has been doing in the last week or two. The Fed has come to realize that just lowering interest rates isn't enough to combat this credit crunch, because those lower rates aren't actually getting through to the households and the businesses that need the money and the reason why is that banks and investment banks and others have become very reluctant to lend.

So the Fed has had to find other creative ways of trying to get cash into those corners of the financial market where it doesn't normally operate. And one of the most innovative was on Sunday they basically said, "We're now going to lend to investment banks on much the same terms that we lend to commercial banks."

And what we have seen over the last two days is a growing conviction in the markets that these moves are enough to prevent a spread of the panic that we saw bring down the Bear Stearns investment bank last week.

RAY SUAREZ: And what's the difference between an investment bank and a commercial bank?

GREG IP: The investment bank is a securities dealer, like Merrill Lynch, whereas a commercial bank is a bank that accepts deposits. And there's a crucial distinction, between commercial banks, since the Fed was created 95 years ago, have had a special relationship. They get to borrow from the Fed. They get deposit insurance.

But, in turn, they submit to a very tight system of regulation. That's really not the case with the investment banks, like Bear Stearns and Lehman Brothers and Goldman Sachs, so these were very bold moves by the Fed.

Hedging inflation worries

RAY SUAREZ: Well, that fed funds rate is now down to 2.25 percent. Is there much room left if they feel more cuts are needed down the road?

GREG IP: It does look like the Fed is running out of ammo. They cannot obviously cut rates any more by how much they've already done.

That said, I think the bigger risk here, Ray, isn't the fact that they are running out of ammunition. It's that the more they go, the more people are going to worry that they are taking their eye off the risk of inflation.

Oil is over $100. We had another negative report today on wholesale price inflation. The dollar has become very weak, because foreign investors are wondering about how complacent the Fed may have become about inflation.

And that's one reason we got the smaller rather than the larger rate cut today. The Fed probably will move again, but how much further they move I think is limited by these continued problems on the price front.

Risk of falling dollar

RAY SUAREZ: Are there risks here? Are there big holders of dollars that saw this as bad news?

GREG IP: Today we saw the dollar fall further against some other currencies, like the euro, but it actually made back a little bit of that loss after the Fed's news was announced.

There's always the possibility that if foreign investors get the idea that the United States just doesn't care about the value of the dollar that they could start dumping them en masse. And you could actually get a panicky situation, which would send interest rates up instead of down.

It's a very small probability, but it's one that the Fed and the U.S. Treasury cannot be complacent about.

RAY SUAREZ: Has the further availability of cash -- and I'm opening this cash window at the fed -- and these lower rates combined now filter down to where the way most consumers borrow money or obtain credit will see some effect, will see some loosening?

GREG IP: It has begun to have some impacts. For example, mortgage rates, which actually had gone up earlier this year, even as the Fed was cutting interest rates, they've started to move down again.

And the reason why is that investors who previously were unable to find buyers for the mortgage-backed securities, which is how most home mortgages are financed, they're now finding buyers. And that's filtered down to the average person who's looking for a mortgage.

But I'm not going to get too excited just yet, because we've seen quite a few false dawns since this crisis began last summer. You know, the Fed makes a new, aggressive move either with interest rates or one of these other creative steps. The markets improve; lending rates drop.

And then another sector of the economy that we didn't know that was exposed to this credit problem suddenly announces that it's got a problem, and the whole thing starts over again.

Economic outlook

RAY SUAREZ: One trader on the floor in New York told a reporter today, "We're in uncharted territory." So how do you set your compass? What's the next thing you're looking for to understand what's to come?

GREG IP: Well, in these sorts of situations, the markets always move well before the economic data becomes conclusive. And we have seen the markets begin to basically price in some very dire scenarios for the economy, more dire than most people actually think are likely.

And yet this bad psychology can become self-fulfilling if the people who are lending money simply don't want to lend it any longer. What I would like to see is a sense that that psychology is improving.

Look, we're not going to get home prices up anytime soon. We have some ways to go before home prices fall to a new sustainable equilibrium level. Employment is probably going to be weak for a while, and consumer spending, given the fact that consumers basically haven't had any saving to fall back upon.

But it's possible that, if the psychology finally turns around, you can begin to form a bottom, and that the recession that so many people do now expect will be a mild one instead of a severe one.

RAY SUAREZ: Greg Ip of the Wall Street Journal, thanks a lot.

GREG IP: Thank you, Ray.