The Federal Reserve cut interest rates by half a point Tuesday, causing major gains in the stock market. Financial analysts discuss the move and what it means for the U.S. economy.
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Today's Fed move was surprisingly aggressive. In a unanimous vote, members of the Federal Open Market Committee made two interest rate cuts. They slashed the federal funds rate by a half-point, lowering the rate banks charge each other to borrow money, and the central bank also reduced the discount rate by a half-point, as well. That's the amount the Fed charges for direct loans to banks.
In a statement the Federal Reserve said, "The tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally."
For some analysis of the Fed's action, we turn to Bill Cheney, chief economist at John Hancock Financial Services; and Philip Jefferson, a former Fed economist, he's now a professor of economics at Swarthmore College.
And, Professor, were you surprised by the size of the rate cut?
PHILIP JEFFERSON, Former Fed Economist:
I was surprised by the size of the rate cut, because what the Fed was trying to do here, I think, is, on the one hand, support the economy and make sure that the troubles in the financial market do not spread to the broader economy.
But at the same time, they were in a position where I thought it would have been important to also signal to financial markets that, if you find yourself in a difficult position because of lenient banking and lending practices, the Fed was not necessarily going to come in and clean up the mess afterwards.
And the size of this particular cut leads me to believe that the concern about the economy, combined with the desire to improve the balance sheets of financial institutions, really argued towards reducing the interest rate by 0.5 percent. And they were able to do that, also, because of the news about inflation, in that the outlook for inflation certainly was not severe at all, and so maybe they felt as though they had more room than market participants originally thought.
Bill Cheney, as we look at the economy overall, what was the state of play that made an interest rate cut necessary in the first place?
BILL CHENEY, Chief Economist, John Hancock Financial Services:
I think the way I look at this is that the Federal Reserve, a couple of months ago, was primarily concerned about inflation when they thought that the economy looked as if it was on a pretty robust growth path. Two or three months later, the picture looks really different.
The housing market is weaker than we thought it was. The labor market has cooled off a bit. And then we have this sort of seizure in financial markets, which while I agree with your other guest that the Fed doesn't care about the well-being of gamblers on Wall Street, they do care about the way that this phenomenon seems to have sort of locked up the credit channels in some ways and made certain parts of the market for credit that impinge on real people, businesses and consumer borrowers.
So the Fed now really wanted quite seriously to take out some insurance against the possibility that all these sources of weakness would add up to a real problem and head us into a recession. I don't think they expected a recession, even if they did nothing, but it's an important kind of insurance. And they had plenty of room to do it. The federal funds rate was high enough that this action really is more like taking your foot off the brakes. It's not really giving the economy a whole lot of gas.