Shedding Light on the Latest Fed Rate Cut

Traders on Wall St. i i

Traders work the floor of the New York Stock Exchange after Federal Reserve policymakers announced a cut in the federal funds rate. Hiroko Masuike/Getty Images hide caption

itoggle caption Hiroko Masuike/Getty Images
Traders on Wall St.

Traders work the floor of the New York Stock Exchange after Federal Reserve policymakers announced a cut in the federal funds rate.

Hiroko Masuike/Getty Images

The Federal Reserve policymakers on Tuesday cut the federal funds rate by three-quarters of a percentage point, less than what many in the financial markets wanted. But it was still an aggressive move by historic standards, and it underscores how concerned most Fed officials are about the economic slowdown.

In cutting the federal funds rate, the Fed said the outlook for economic activity had weakened: Consumer spending has slowed and labor markets have softened. Meanwhile, credit conditions have tightened and housing activity has contracted. All of these conditions are likely to weigh on growth for months ahead.

The rate cut follows a weekend in which the Fed extended credit to new kinds of financial institutions and engineered the bailout of investment bank Bear Stearns.

"The Fed is using sort of the blunt force of a funds rate cut to help provide growth for the economy. At the same time, [the Fed is] augmenting that with these other very specific types of activities to provide liquidity where it's needed most," says Stuart Hoffman, chief economist at PNC Financial Services.

In its statement on Tuesday, the Fed said downside risks to economic growth remain, which is usually taken by economists to mean the Fed may cut rates even further. But the statement included some anxious words about price pressures: It said inflation has been elevated and some indicators of inflation expectations have risen. That suggests some Fed members may have been ambivalent about the size of the cut.

And indeed, two members dissented, saying they wanted less aggressive moves.

"When you get two dissents, this was probably a very dicey discussion," says Hoffman.

A Mistake?

Tuesday's cut is the second of the same size this year. It brings the rate down to 2.25 percent. The rate was 5.25 percent as recently as last September.

Fed officials are hoping that by making money cheaper to borrow, they'll encourage investment and keep the economy from tipping into a recession — if it's not already there.

But economist Richard Yamarone of Argus Research believes the cuts in interest rates are a mistake. He says the problem right now isn't that money is too expensive. Instead, Yamarone says the real problem is widespread mortgage-market losses, which have hurt confidence in the major banks and made people nervous about investing in the U.S. economy.

"Many of these balance sheets in these Wall Street trading firms have worthless paper, and the Fed cutting the federal funds rate by 75 basis points is not going to cure that," he says.

Yamarone says people aren't going to invest their money if they are worried about the economy, no matter how low interest rates fall. And he says the steady drop in rates may actually hurt the economy in the long run.

Federal Reserve officials kept interest rates artificially low after the Sept. 11, 2001, terrorist attacks and that helped create the housing bubble. Yamarone says the same thing may be happening now.

"Excessive rate cuts like this are what brought the hangover," according to Yamarone, and the Fed "just gave us a little hair of the dog that bit us."

But that's a minority view right now. Most economists say the sharp slowdown in growth and the troubles in the banking sector represent a big threat to the economy. Fed policymakers, they say, need to do whatever it takes to avert that.

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