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Fed Cuts Key Interest Rate
As Recession Fears Well Up

January 22, 2008 5:51 p.m.

WASHINGTON -- Federal Reserve Chairman Ben Bernanke, putting caution aside, orchestrated a steep cut in interest rates just a week before a scheduled policy meeting in an effort to short-circuit a downward spiral of investor confidence and tightening credit.

[fed funds]

The three-quarters of a percentage point cut in the Fed's short-term interest rate target -- to 3.5% -- could help restore confidence to investors and counter the threat of recession. But the reduction risks making the Fed look like it panicked in response to market developments.

The move is unlikely to be the last cut, the Fed indicated. "Appreciable downside risks to growth remain," it said, vowing to "act in a timely manner as needed to address those risks." Markets see a high likelihood of a half-point cut at next week's meeting, scheduled for Jan. 29-30, and see the rate falling as low as 2.25% by the end of the year. (Read the Fed's statement.)

The immediate market response was positive. The Dow Jones Industrial Average, down as much as 464 points early in the morning, recovered to close just 128 points lower at 11971.19. European markets, which were falling steeply, reversed course and closed higher on the Fed's action. (Read related article.)

The Fed said it acted because of "weakening of the economic outlook and increasing downside risks to growth. Broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets."

The Fed statement suggested a downshift in its worries about inflation. It said it expects "inflation to moderate in coming quarters" though it will "monitor inflation developments carefully."

The move would be "pointless" if it merely shifted a scheduled rate cut ahead by a week, said former Fed governor Laurence Meyer, now vice-chairman of consultants Macroeconomic Advisers LLC. "Instead, today's move was driven by a desire to get a larger cumulative change in the federal funds rate by the end of the month." He predicted a half-point cut next week.

Vincent Reinhart, a former top staffer at the Fed now a scholar at the American Enterprise Institute think tank in Washington, said the Fed may have put itself in "harm's way" by basing its action so explicitly on market developments. "If markets go down after you've acted, do you jeopardize some of your credibility? I think they did."

The move was the first rate cut between scheduled meetings of Fed policymakers since the immediate aftermath of the Sept. 11, 2001 terrorist attacks, and came closer to any scheduled meeting since the Fed began announcing rate changes in 1994.

The Fed last cut the target for the federal-funds rate, charged on overnight loans between banks, by as much in 1982, when it was lowered a full point. Prior to 1994, however, fed funds rate cuts weren't announced, and the Fed relied on the less-important discount rate, charged on direct Fed loans to banks, to signal its actions. It cut that rate a full percentage point in 1991.

Eight of the 10 currently voting members of the Federal Open Market Committee voted in favor of the move. Fed governor Frederic Mishkin was traveling and unavailable; the other, Federal Reserve Bank of St. Louis President William Poole, dissented, because "did not believe that current conditions justified" moving before the meeting, according to the Fed

The Fed's action was welcomed by the Bush administration. Treasury Secretary Henry Paulson told the U.S. Chamber of Commerce in response a question that the rate cut is "constructive" and "shows this country and the rest of the world that our central bank is nimble and able to quickly respond to market conditions."

"That should be a confidence builder," Mr. Paulson told the business executives.

In his prepared speech, Mr. Paulson predicted that President Bush and Congress would reach agreement on an emergency economic package "before winter turns to spring."

[Ben Bernanke]

"We need to do something now, because the short-term risks are clearly to the downside, and the potential benefits of quick action to support our economy have become clear," Mr. Paulson said.

Last week, Mr. Bush announced his support for a stimulus plan valued at about $145 billion. Top on the administration's list of possible measures are tax rebates for consumers and new rules to allow businesses to immediately write off a substantial portion of the cost of new equipment.

The rate cut follows five months of gradualism in which the Fed has seen each of its last three rate cuts rapidly overtaken by events, as the credit crunch and housing collapse deepened. Mr. Bernanke had been balancing those risk against still-high inflation. But he signaled on Jan. 10 that he had shifted his focus principally to supporting growth as employment, retail sales and manufacturing activity all weakened sharply. While some Fed officials mulled the merit of an intermeeting cut then, Mr. Bernanke figured the speech would serve to recalibrate market expectations enough that he could wait until next week's meeting.

That game plan changed Monday in response to a double dose of bad market news: first, that several major bond insurers could lose their triple-A credit ratings, which would shift the risk of default on an additional billions of dollars of debt back onto banks, further constraining their lending; and then, on Monday, the global stock market rout, which cast into doubt the rest of the world's ability to ride out a U.S. recession.

On the presidential campaign trail, candidates Hillary Clinton, a Democrat, and John McCain, Republican, were quick to react to the Fed's surprise three-quarter percentage-point rate cut this morning -- but offered quite different messages.

"This is a global economic crisis," Sen. Clinton said at a news conference early this morning. "It has pushed the Fed into an emergency meeting and a rate cut in an effort to take whatever action can be taken on the monetary side to begin to try to stabilize this situation which is obviously deteriorating."

The New York senator went on to say that President Bush already should have convened a "working group on financial markets….This has to be regulated across markets with regulators here and regulators around the world." She also urged top lawmakers and the White House to reach agreement at their meeting today on a stimulus package that can clear Congress quickly.

Sen. McCain, on the other hand, didn't apply the pressure, though he did put in a plug for his stimulus plan, consisting mostly of tax cuts, and a plug for the Fed. "The role of the Federal Reserve is to ensure that our financial markets are well-functioning and to support economic growth," the Arizona senator explained in a statement. "I am confident that the action taken this morning to cut two key rates will support these goals. The U.S. economy has proven to be quite resilient. I am concerned about financial market events, but with the right leadership and pro-growth policies the economy can weather this upheaval."

In Boca Raton, Fla., Mitt Romney, former governor of Massachusetts and former head of Bain Capital, acknowledged concerns about the stock market, and mentioning his investment in a blind trust at Sun Capital, which was started by one of the event's attendees. "I hope I still have it at Sun Capital and I hope that as of tonight Sun Capital still has it too, so we're all a little nervous about that," he joked.

Getting serious -- and optimistic -- Romney said: "I can tell you from my own personal experience that every time I've seen things really get scary and the markets really collapse that I put aside that fear for a moment and say, 'Ah-ha, is this a buying opportunity?' Because my experience has always been what goes down, comes back up."

He then returned to the presidential pitch, saying that restoring the economy's health "is going to require, I believe, action on the part of leadership in Washington to do those things which will convince the world that America is going to come back strong and our economic foundation is secure."

--Sudeep Reddy, Michael M. Phillips, Amy Chozick, Alex Frangos and Elizabeth Holmes contributed to this article.

Write to Greg Ip at

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