Fed acts to head off slump

The Baltimore Sun

WASHINGTON -- The Federal Reserve staged another pre-emptive strike against a potential economic slowdown yesterday, cutting short-term interest rates by a quarter percentage point to the lowest level in almost two years.

After a half-percentage-point cut in September, the central bank continued its attack against the prospect of more economic damage from a severe housing correction that has put financial markets in turmoil, largely because of a surfeit of subprime mortgages to marginally qualified borrowers.

It was a Halloween treat for financial markets, which moved strongly upward at the end of the day, with the Dow Jones industrial average climbing 137.54 points.

The Fed gave Wall Street just what it had expected. And the move also will help many Americans with adjustable-rate mortgages get a slightly better deal when their rates are reset in coming months.

The Fed reduced its benchmark federal funds rate, the rate that banks charge each other for borrowing, from 4.75 to 4.5 percent, meaning that short-term interest rates are now three-quarters of 1 percent lower than they were before its September meeting. In coming months, these cuts could stimulate the economy.

But with the move, Chairman Ben S. Bernanke's central bank also indicated that a pause in rate-cutting is likely at its meeting next month.

This signal came in two ways. First, it said that inflation risks now are about the same as recession risks, a sign that it wants to keep its eye on rising prices with oil at more than $90 a barrel. And, Thomas Hoenig, president of the Kansas City Federal Reserve Bank, dissented, a rare move on monetary policy decisions.

To Diane Swonk, an economist at Chicago's Mesirow Financial, the dissent "indicated the debate was fairly heated and the consensus was difficult to get," even though the vote was 9-1 in favor of a rate cut. And that could foreshadow more dissension in future meetings.

Though a government report showed yesterday that the economy moved up strongly in the third quarter, rising at an annual rate of 3.9 percent, many economists believe the fourth quarter and the first quarter of next year could bring about much slower growth because of lingering problems in the housing sector.

The Federal Open Market Committee, the Fed's policymaking arm, indicated that "it was taking a little bit of an insurance policy against a worse-case scenario," meaning a recession, said Carl Tannenbaum, chief economist at Chicago's LaSalle Bank.

David Wyss, chief economist at Standard & Poor's, the credit-rating firm, said the economic growth could taper off in the fourth quarter of this year and the first quarter of next year to as low as 1.5 percent. The housing market is still weak, Wyss said, and concerns are rising about the strength of the manufacturing sector.

In its statement, the FOMC said that "the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction." It added that its action "should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time."

The central bank seemed slightly less worried about a credit crunch that developed in late summer. Then, many companies found it hard to borrow funds for short-term operations because of a surplus of securities backed by subprime mortgages. "Economic growth was solid in the third quarter, and strains in the financial markets have eased somewhat on balance," the central bank said in trying to reassure financial markets.

The current economic situation is turning into a major test for Bernanke, who took over the chairman's job from Alan Greenspan last year and is grappling with one of the most complex economic problems in recent times. After being accused of waiting too long to address the rising turmoil in financial markets, he moved swiftly to pump more money into the economy and reduce interest rates.

The federal funds rate is now at the lowest rate since Jan. 31, 2006. The central bank also reduced its discount rate, the rate it charges financial institutions for direct borrowing from the Federal Reserve, to 5 percent.

Clearly the Fed was looking several months ahead when it made its decision. The Commerce Department earlier in the day reported the 3.9 percent rise in third-quarter growth, as measured by gross domestic product, the output of the nation's goods and services.

Now, a key question is whether the central bank has reached what economists call a "neutral" interest rate, the rate that theoretically permits solid economic growth without inflation. Many analysts say that the Fed is close to neutral at 4.5 percent, although some believe that it could go lower.

"We now expect the Fed to hold at 4.5 percent through 2008, or until it gets convincing economic data either of accelerating inflation or weaker economic growth than is expected," said Scott Anderson, senior economist at the Wells Fargo economics unit.

William Neikirk writes for the Chicago Tribune.

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