The Federal Reserve's vote to cut key interest rates by half a percentage point aims to keep the economy growing at a time when the world's credit markets are taking a beating.
The Fed's decision Tuesday to cut the federal funds rate – charged on overnight loans between banks — one-half a percentage point to 4.75 percent shocked economic observers. They were poised for a cut of 0.25 percent.
The Fed also cut its discount rate – charged on direct loans to banks – by the same amount to 5.25 percent.
While the cuts immediately boosted stock prices, they are expected to take some time stimulating the beleaguered housing industry.
Economist Naraman Baravish of the research firm Global Insight says the move was a response to the current turmoil in the credit markets.
"What it does is it sends a very strong signal to markets that the Fed is on top of things, that the Fed does not want this crunch to become anything worse and especially not to spill over to the rest of the economy," Baravish said. "So it's a way of signaling to the market: 'We know there's a problem. We're doing something about it. Don't worry. Don't panic."
The rate cuts were a response to the first real crisis of Federal Reserve Board Chairman Ben Bernanke's tenure.
The credit markets have been roiled by the downturn in subprime mortgages. A lot of investors have lost money in mortgage-backed securities, and no one can really say how far the losses extend. That has made lenders gun shy about where they put their money.
It has also cast a pall over the economy, and spread to other countries.
Former Fed Governor Alice Rivlin said the Fed's move is designed to assuage lenders' fears.
"It makes it a little cheaper for the banks to borrow money, and therefore cheaper for them to lend money," said Rivlin, now a director of Economic Studies at the Brookings Institution. "What they're hoping is this will reassure all of the financial services institutions that things are returning to normal and they might as well go back to lending to credit worthy borrowers wherever they can."
The rate cut proved the fulcrum to propel financial markets. The battered Dow Jones Industrial average rallied 335.97 points, or 2.5 percent to 13,739.39. Among the best performing shares were home builders, which have had a spectacularly bad year.
Outlook for the Deteriorating Housing Sector Remains Unclear
The interest rates controlled by the Fed are short-term rates. Cuts in those rates can make certain kinds of consumer credit cheaper. However, mortgages aren't typically included in the offers for cheaper credit. Rates for long-term mortgages tend to be set by the market.
And, while mortgage rates tend to follow Fed rates, the process can take time.
Edward Leamer, who heads the UCLA Anderson Forecast (a quarterly prediction of the U.S. economy) said even if mortgage rates do come down it, won't be enough by itself to end the housing recession.
"There's not going to be a lot of joy out there in those neighborhoods where the foreclosures and delinquencies are already high," said Leamer.
He notes that housing prices are still too high in many places and many people who want to buy houses can no longer qualify for mortgages.
Alice Rivlin agrees there is a supply problem.
"We built too many houses and we have an excess stock of housing, particularly high-end housing. We're going to have to work through that," she said.
As for where the Fed will go from here, Rivlin said she sees nothing in the Fed's announcement to suggest there will be any more rate cuts.
But other economists disagree and predicted more moves by the board in October.
All that's certain is that things are changing fast. A little more than a month ago Fed policymakers were downplaying the risks of the mortgage meltdown.
Now they have reversed course and made clear they're ready to keep cutting rates if conditions warrant it.