'Marketplace' Report: Cutting Interest Rates

How many times can the the Federal Reserve possibly cut interest rates? It's already been quite a few, and they are expected to chop them again Tuesday. We examine how this signals a changing role for the Fed.

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ALEX COHEN, host:

From NPR news, it's DAY TO DAY. The Federal Reserve slashed interest rates again today. This time they cut the key federal funds rate by three-quarters of a percentage point, bringing it to 2.25 percent. Today's cut is part of a more aggressive approach to shoring up the economy. Here to tell us about it is MARKETPLACE's Janet Babin.

Janet, this cut was deep, but it wasn't quite as big as what the markets were expecting, right?

JANET BABIN: That's right, Alex. Many were hoping that the Fed would cut the rate by one percent. But it appears that the Fed is worried that a steeper cut might have ignited inflation. No doubt the Fed wants to get banks lending more money; it wants to infuse the market with liquidity. But if you make borrowing money too cheap, it can stir inflation. So three-quarters of a point.

COHEN: And the Fed has been up to all sorts of things over the past few days. Why so much so quickly?

BABIN: That's right. It's been an extraordinary couple of days. Over the weekend the Fed orchestrated the sale of failing investment bank Bear Stearns to JP Morgan Chase, and that deal includes $30 billion in special Federal Reserve financing for Bear Stears's less liquid assets, in case that money is needed to shore up those assets, and ultimately taxpayers would foot that bill through the Fed.

What the Federal Reserve also did was open its discount window to provide cash to a wide range of banks, investment banks as well as commercial banks, and it says those transactions are going to remain anonymous because, you know, think about it; if you knew your bank was headed to the Fed discount window, you'd think something was wrong. And rumors are ultimately what fueled the bank run on Bear Stearns last weekend. As to why the Fed made these moves, it's trying to head off a severe depression or some sort of recession in the U.S. economy.

COHEN: But Janet, couldn't you argue that all of these moves by the Fed kind of puts taxpayers on the hook for risk-taking that was done by investment banks?

BABIN: That's right. Some complain taxpayers were left holding the bag here. It gets to this whole question, Alex, of moral hazard. And moral hazard is sort of like say you have kids; you don't want them to hurt themselves, but if you don't let them hurt themselves at all, if you protect them too much, they end up never learning anything and you have to keep bailing them - bailing them out, rather. So too with the bailout of these banks. If the banks are behaving recklessly, some say that they'll keep behaving recklessly if you keep bailing them out. Duke University Professor Campbell Harvey told me it's a trade-off.

Professor CAMPBELL HARVEY (Duke University): In doing these bailouts you increase the moral hazard problem. You basically invite greater risk-taking in the future, and that has a cost. If you don't do the bailout, then you cause immediate disruption in the market and possibly push us into a very deep recession.

BABIN: So the ultimately cost, the ultimate moral hazard here, could be a depression.

COHEN: Thank you so much, Janet. That is Janet Babin of Public Radio's daily business show, MARKETPLACE.

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