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Fed Cuts Rates by Quarter Point
Amid Strains in U.S. Economy
December 11, 2007 5:00 p.m.
The Federal Reserve cut short-term interest rates for the third time this fall to soften the economy from a nascent credit crunch, and gave itself room to cut more.
The Fed cut both to its main short-term rate target and the "discount rate" charged on direct Fed loans to commercial banks, by a quarter of a percentage point respectively to 4.25% and 4.75%.
Wall Street economists had generally expected a quarter-point cut in the federal funds rate, charged on overnight loans between banks, and a half-point cut in the less important discount rate. A large minority of economists had projected a half-point cut in the federal funds rate.
But it was more than the Fed thought it would have to do when it last met in late October, and the accompanying statement left the door open for more, though without a presumption the Fed would deliver.
Investors sold stocks heavily in disappointment that the Fed rate cut wasn't larger, and that the Fed's statement didn't offer a clearer promise of more rate cuts later. However, stocks are still more than 500 points higher than they were before Federal Reserve Vice Chairman Donald Kohn set off a rally last month when he indicated the Fed would cut rates at its December meeting.
"Well, the boys blew it again. You wonder which economy they are looking at and what it is they are thinking about," said Alfred Kugel, chief investment strategist for Atlanta-based investment-management firm Atlantic Trust.
"They are still behind the curve. They've got to do more," said Mr. Kugel, who added that the Fed's failure to stimulate the economy more aggressively has increased the risk of recession. Two Wall Street firms, Morgan Stanley and Keefe Bruyette & Woods, issued recession forecasts this week.
Leading the declines were financial stocks, which had been rising on hopes of strong Fed action to resolve the credit-market crisis, and stocks of companies whose profits are most closely tied to economic growth, such as transportation firms, retailers and industrial companies. Smaller stocks suffered more than big ones, on the theory that they are less stable in times of economic trouble.
"Economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending," the Fed said. "Moreover, strains in financial markets have increased in recent weeks." (Read the full statement.)
At the same time, "some inflation risks remain" due to elevated energy and commodity prices.
Unlike last October, when the Fed said the risks of weaker growth and higher inflation were roughly balanced, implying no predisposition to cut rates again, Tuesday it elected not to assess the balance of risks. It said it "will continue to assess the effects of financial and other developments on economic prospects and will act as needed."
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The Fed's rate cut comes as the economy appears to have ground to a halt in the current quarter after growing at an annual rate of 4.9% in the third. The primary cause is a continued slump in new home construction, a trend likely to continue given still-bulging inventories of unsold homes. But consumer spending has also slowed sharply under the weight of sharply higher energy prices and slowing job growth. Macroeconomic Advisers, a widely-followed forecasting firm, said Tuesday it now expects the economy to contract slightly in the current quarter, the first time it would have done so since the recession of 2001. It expects growth to return to 1.8% in the first quarter of next year.
The current slowdown isn't the overriding concern at the Fed, which had expected growth to be subdued through next spring before recovering to a normal pace by midyear. But the current weakness may now be compounded by a nascent credit crunch.
Borrowing rates for homeowners, consumers and corporations have remained stable or actually risen in recent months despite the drop in the Fed's short-term interest rate target, as lenders demand a larger cushion for the risk of default. For example, the 30 year "jumbo" mortgage rate, for loans larger than $417,000, has climbed to almost 6.9% from 6.7% at the end of October, while the typical auto loan rate has fluctuated around 6.9% in that period.
At the same time, the volume of lending is down. Issuance of new securities backed by auto loans since July is down 38% from the same period a year earlier, according to Deutsche Bank. On the other hand, issuance of securities backed by credit card receivables is up sharply.
The reason for tighter lending conditions appears to be a combination of concern about recession, which would cause defaults to rise; avoidance of securities that contain hard-to-value loans such as subprime mortgages; and the banks and others to preserve their own cash and bolster capital.
These conditions make the Fed's job tougher than usual to discern the right stance for interest rates. Typically, it judges the outlook of the economy based on more conventional factors like how much inventories or employment are out of line with normal levels, or how high its own interest rate target is.
Brian Sack, an economist at Macroeconomic Advisers LLC, said the Fed faces two major unknowns: "First, how will financial conditions evolve, and two, how do financial conditions affect the real economy?"
To date, tighter credit appears to have only materially affected homes, and there have actually been faint signs of stability in home sales in the last month. In part, that's because rates on conventional mortgages -- those guaranteed by Fannie Mae and Freddie Mac -- have edged lower.
Looking forward, though, tighter borrowing conditions seem certain to weaken growth further because the U.S. economy is so highly dependent on credit.
Write to Greg Ip at greg.ip@wsj.com
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