TOPICS > Economy

Fed Makes Aggressive Rate Cut in Bid to Loosen Credit Markets

October 29, 2008 at 6:10 PM EDT
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In a new move to stem the impact of the financial crisis, the Federal Reserve cut the federal funds rate by half a percentage point to 1 percent Wednesday. Krishna Guha, chief U.S. economics correspondent for the Financial Times, discusses the move.
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JIM LEHRER: Today’s Federal Reserve decision to cut interest rates again. Here to explain the what’s and why’s of the action is Krishna Guha, chief U.S. economics correspondent for the Financial Times.

Krishna, welcome. Remind us again what specific rate it was that was cut today.

KRISHNA GUHA, Financial Times: So, Jim, this is the Fed funds rate. It’s the basic underlying interest rate in the economy. It was 1.5 percent. The Fed cut it by half a percentage point. It’s now 1 percent.

JIM LEHRER: And the reasoning behind that was what?

KRISHNA GUHA: Well, the Fed is going all-out to try to offset some of the severe tightening in credit conditions that’s happened over the last couple of months with all the turmoil in the financial sector.

By reducing the interest rate, it hopes to bring down the actual cost of borrowing for people like you and me and for companies out there in the economy.

Two types of interest rates

Krishna Guha
Financial Times
Every loan in the economy is essentially made up of two halves. There's the underlying risk-free rate. That's the rate the Fed sets, now 1 percent. And then there's a risk premium [...] you pay because you're a riskier or less risky borrower.

JIM LEHRER: Well, give us the ripple scenario, the good scenario that they're hoping for, that this happened today, and what will happen in sequence after that.

KRISHNA GUHA: Well, Jim, every loan in the economy is essentially made up of two halves. There's the underlying risk-free rate. That's the rate the Fed sets, now 1 percent. And then there's a risk premium. That's the extra you pay because you're a riskier or less risky borrower.

The Fed's trying to tackle both of these elements. It's reducing the underlying rate; that's what it did today. And it's also trying to hammer down those risk spreads in the economy; that's why it's doing all these new and often unconventional lending operations.

JIM LEHRER: Now, is it possible to go below 1 percent? In other words, is there any more give in this operation?

KRISHNA GUHA: Well, the answer is yes. And here's how it works. If at some point the Fed gets to zero interest rates and wants to ease policy further, it obviously can't go negative.

But what it can do is try to bring down interest rates on the longer term. You see, the Fed funds rate, the interest rate we always talk about, that's an overnight rate. It's a rate to borrow for a day.

But if that rate goes down to zero, it probably still costs money to borrow, let's say, for three months or two years. So what the Fed would do is it would start to target longer term interest rates in the economy, try and target the three-month rate or the two-year rate, thus making the overall set of borrowing costs in the economy cheaper.

Cut aims to loosen credit

Krishna Guha
Financial Times
[The Fed has] been able to offset what's happened in the markets, this extraordinary credit crisis, to some degree. But they haven't been able to get credit flowing in normal ways to households, to businesses, to keep the economy growing.

JIM LEHRER: And the whole point of this is to -- is to cause people to loan money again, right?

KRISHNA GUHA: That's right. Absolutely.

JIM LEHRER: Everybody in the chain, right? And what's the evidence that any of this up until now was working? Or is there any?

KRISHNA GUHA: Well, the evidence is, frankly, limited. If you talk to people inside the Fed, what they'll tell you is, look, if we hadn't done this stuff, everything would have been much, much worse. And that's probably true.

They've been able to offset what's happened in the markets, this extraordinary credit crisis, to some degree. But they haven't been able to get credit flowing in normal ways to households, to businesses, to keep the economy growing.

Top Fed officials will tell you today they didn't think that interest rates alone can do it anymore. And that's why they were very keen supporters of the federal government's rescue plan, including injecting capital into the banks to make them stronger.

If the banks are stronger, they should feel more confident about lending, and they should also feel more confident about doing business with each other.

JIM LEHRER: And late today, in another action, the Treasury Department did put money into nine banks, right, of $250 billion, something like that?

KRISHNA GUHA: Well, the Treasury is, indeed, putting money into a wide number of banks, including some eight or nine large banks -- the key systemically important banks, the biggest national banks, the ones that can't afford to let go under -- but it's also providing capital for smaller banks, including some community banks.

Wall Street's reaction

Krishna Guha
Financial Times
People are terrified as to what could still happen to the economy, but at the same time they see stocks as being really beaten down and potentially offering a lot of profit in the long haul. So the mood swings from one to the other.

JIM LEHRER: All right, now, finally, the impossible question, Krishna. How do you explain Wall Street's reaction to this? As you know, it was very level this morning. And then, boom, it suddenly went up over 200 points and then, the last few minutes, it fell down 74 points, a 74-point loss. Have you got an explanation, sir?

KRISHNA GUHA: Well, half an explanation. No one really understands what's going on with the markets right now.

Look, the markets are incredibly volatile at the moment. That means they bounce around. And it's partly a combination of fear and greed. People are terrified as to what could still happen to the economy, but at the same time they see stocks as being really beaten down and potentially offering a lot of profit in the long haul. So the mood swings from one to the other.

Trading is also thin. And that means that stocks can bounce up and bounce down.

But when we look at today's trading, we should put it in context. The market went up by 10 percent yesterday. And it was basically give-or-take flat today. That's not a bad development. A lot of people were thinking that, after yesterday's bounce, we might have a slump today. We didn't get it. So some modest reassurance from the market today, I think.

JIM LEHRER: OK. Krishna, I'll take your word for it. That's good news, semi, right?

KRISHNA GUHA: Thanks, Jim.

JIM LEHRER: OK, thank you very much.

KRISHNA GUHA: Cheers.