Fed cuts short-term rates half a point

THE BALTIMORE SUN

Moving in concert with central banks around the world, the Federal Reserve cut short-term interest rates by half a percentage point yesterday in an effort to calm stock markets and forestall a prolonged economic slump in the wake of the terrorist attacks that disabled Wall Street and shocked the nation last week.

Acting before its next regularly scheduled meeting in October, the Fed's policymaking body reduced the target for the federal funds rate, which banks charge each other for overnight loans, to 3 percent - the lowest level since the recession and banking crisis of the early 1990s. Many economists expect the Fed to reduce rates even more.

The central bank announced its move early yesterday, before U.S. markets began trading for the first time since Sept. 11's attacks. But the move wasn't enough to prevent a sell-off on Wall Street, with the Dow Jones industrial average closing below 9,000 for the first time since 1998.

U.S. officials hope yesterday's cut, which was accompanied by a half-point trim in the more symbolic discount rate to 2.5 percent, will combine with a sizable jolt of emergency federal spending to help keep the economy afloat.

"This is exactly what the Federal Reserve is supposed to do," said Anirban Basu, senior economist for Towson University's RESI Research and Consulting unit. "What you have now is a two-pronged attack on the prospect of a recession: one from the Fed, the other in the form of government spending."

Three-way attack

The "attack" yesterday was actually three-pronged, with the additional salvo coming in the form of economic cheerleading from President Bush and other top administration officials.

"I've got great faith in the economy. I understand it's tough right now," Bush said. "But the underpinnings of growth are there."

Treasury Secretary Paul O'Neill said he didn't think that the United States was heading into a recession, adding that it was "conceivable" that U.S. blue chip stocks could reach record highs within a year or 18 months, despite a plunge yesterday.

But many analysts see little chance for the U.S. economy - which was struggling before hijackers drove jetliners into the World Trade Center and the Pentagon last week - to avoid losing ground for the rest of this year.

The Fed move "is not going to prevent us from seeing at least one quarter of negative economic growth. There was a lot of negative momentum to begin with," said Nariman Behravesh, chief economist at DRI-WEFA, a Lexington, Mass., forecasting firm.

"If we're not already in a recession, we're heading into one."

The Fed's move was accompanied by similar reductions in Canada and Europe. The Bank of Canada cut rates by half a percentage point, as did the European Central Bank and the Swiss National Bank.

"I was very glad to see the other central banks go along" with the Fed interest rate cut, said Alan Levenson, chief economist for T. Rowe Price Associates Inc.

Several European bourses appeared to take heart from the Fed's move and closed yesterday in positive territory. But U.S. stocks swooned, with the Dow losing 684.81 points and closing at 8,920.70.

The reductions in the funds rate and discount rate announced yesterday make up only part of the Fed's reaction to the terrorist catastrophe. The U.S. central bank has urged banks and other lenders to go easy on customers with liquidity problems and has made billions in credit available to its European, British and Canadian counterparts.

As a result, so much money is flowing into financial markets that the Fed funds rate may dip below the targeted 3 percent, Fed officials said.

Other U.S. interest rates followed the Fed bellwethers downward yesterday. Interest rates on three-month and six-month Treasury bills fell to their lowest points in nearly 40 years in a $26 billion government auction.

Prime rate lowered, too

Numerous banks lowered their prime rate - what they charge their best customers - to 6 percent from 6.5 percent. The prime rate affects commercial loans as well as some consumer borrowing, such as home equity credit lines.

In theory, lower interest rates are supposed to induce consumers or businesses to buy homes, washing machines, computers or industrial equipment on credit, thus stimulating the economy. In practice, the availability of cheap money doesn't mean people will take advantage of it.

Consumers and corporations are coming off a spending binge that took up most of the 1990s, and many analysts question whether there is enough pent-up demand for the rate cuts to have much effect. Uncertainty over travel safety, business supply deliveries and airlines' financial health will also crimp economic activity, analysts said.

At the same time, reductions in short-term rates by the Fed often take weeks or months to significantly affect consumers. The Fed has little control over mortgage prices and other long-term rates, although some economists say the liquidity infusion represented by yesterday's cuts will affect borrowing of all term lengths.

Car loans, credit-card rates and other consumer rates also typically are slow to respond to Fed moves.

"The housing market has been very strong nationally and much stronger in Maryland," said Pradeep Ganguly, chief economist at Maryland's Department of Business and Economic Development. "As a result, mortgage rates have really not moved very much in spite of all the rate cuts. And I think that will continue to be the case."

Any resumption in international tension - another terrorist outrage or an attack on Afghanistan - could also prevent consumers from spending, analysts said.

T. Rowe Price's Levenson said he expects the economy to contract in both the third and fourth quarters of this year - meeting the technical definition of a recession - and said the economic impact of the terrorist strikes "will be with us for a long time to come."

But some economists say they believe any slump would be brief and relatively painless.

While a recession soon is almost certain, the Fed rate cuts, the boost in federal spending and President Bush's $1.35 billion tax cut will ensure that, "by the first quarter, we'll be back where we would have been" without the fallout from the Sept. 11 attacks, said Peter Morici, professor of international business at the University of Maryland.

1990 recession recalled

Many economists have been comparing the present situation to what happened in the summer of 1990, when Iraq's invasion of Kuwait spurred a recession marked by a lapse in consumer confidence and a stock market decline.

But in the summer of 1990, the federal funds rate was a lofty 8 percent. It took the Fed two years and 17 reductions to get the rate to 3 percent, where it served as the launching pad for the economic boom of the 1990s.

This time, by contrast, the Fed has been loosening credit aggressively since January. The funds rate began 2001 at 6.5 percent, but a meltdown in technology stocks and accumulated economic weakness soon prompted the central bank to start stimulating.

Yesterday's cuts represented the eighth Fed easing this year.

Analysts hope that the economic energy imparted by the earlier cuts will surface and keep this fall's slowdown from being as bad as it might have been.

The billions of dollars that will be spent on fighting terrorism and fixing damage in Washington and New York will also have an effect, said Thomas Carpenter, chief economist for ASB Capital Management in Washington.

After a downturn in the third and fourth quarters of this year, Carpenter is predicting a so-called "V-shaped" quick-recovery rebound for the United States.

"When we come out of this," he said, "we're going to come out ... at a fairly steep angle."

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