Fed cuts rates to aid world economy

October 8, 2008 11:40:42 PM PDT
In a rare coordinated move, the Federal Reserve and other major central banks from around the world slashed interest rates Wednesday to prevent a mushrooming financial crisis from becoming a global economic meltdown.

The decision sent Wall Street on a roller coaster ride. The major indexes moved in and out of positive territory, with the Dow Jones industrials at times falling more than 200 points or rising more than 100.

Overseas markets tumbled on worries that the move wouldn't immediately help ease the pain from the financial crisis.

The Fed reduced its key rate from 2 percent to 1.5 percent. In Europe, which also has been hard hit by the financial crisis, the Bank of England cut its rate by half a point to 4.5 percent and the European Central Bank sliced its rate by half a point to 3.75 percent.

The central banks of China, Canada, Sweden, and Switzerland also cut rates. The Bank of Japan said it strongly supported the actions.

"The recent intensification of the financial crisis has augmented the downside risks to growth," the Fed said in explaining the coordinated action, the latest in a series of bold moves meant to pry open tight lending and revive the global economy.

The Dow Jones industrials, already down 875 points this week, rose 85 points in afternoon trading.

Treasury Secretary Henry Paulson said Wednesday that global financial markets remain severely strained, underscoring the need for quick action to implement the government's $700 billion rescue program.

The Fed's action will reduce borrowing costs almost immediately for U.S. bank customers whose home equity and other floating-rate loans are tied to the prime interest rate. Bank of America, Wells Fargo and other banks cut their prime rate by half a point to 4.5 percent after the Fed announcement.

White House spokesman Tony Fratto welcomed the cooperation among the Fed and other countries' central banks to battle the crisis. "It's important and helpful that central banks are working in a coordinated way to deal with stress in the financial system," Fratto said.

House Speaker Nancy Pelosi, who was in Denver Wednesday to tour a hospital, also praised the decision. But she said Congress may need to go back into session to pass another economic stimulus package worth about $150 billion.

The first economic plan this year cost $168 billion and sent tax rebate checks to most individuals and couples and awarded tax breaks to businesses.

The House did pass a $61 billion economic aid proposal last month before lawmakers left Capitol Hill ahead of the Nov. 4 election. But a similar plan failed to pass the Senate.

The country's presidential contenders also embraced the action. "This is a global crisis that requires a global solution," said Democrat Barack Obama. Republican rival John McCain hoped it would contain the "financial crisis spreading across the globe."

Some analysts were skeptical that the coordinated rate reductions would do much to turn things around.

"At first blush, while this is a big step, it is unlikely to prove sufficient to stem the rot. Additional rate cuts are likely and further measures to inject liquidity and re-capitalize banks are needed," said Marc Chandler, global head of currency strategy at the investment firm Brown Brothers Harriman.

The rate cuts came against a backdrop of increasing anxiety in global financial markets. Investors have been fleeing shares on worries that neither the Fed, nor other central banks, could move fast enough to stop the rising turmoil.

European indexes fell. In Britain, the FTSE-100 fell 5.2 percent, Germany's DAX dropped 5.9 percent, and France's CAC-40 dropped 6.3 percent.

In Asia, Japan's Nikkei 225 closed 9.38 percent lower and Hong Kong's Hang Seng tumbled 8.17 percent hours before the rate cuts were announced; their declines showed the extent of the worldwide gloom.

The worldwide gloom followed a sell-off in U.S. markets late Tuesday, where major stock indexes slid 5 percent. The rout brought the Dow Jones industrials to its lowest close in five years. The blue chip index is now around 33 percent below its record close of 14,164.53 a year ago.

The Fed's action Wednesday was the latest in a long series of moves over the last several weeks that the central bank has taken in coordination with other federal agencies, Congress and the White House to shore up a financial industry stung by bad loans, mounting losses and -- in many cases -- collapse. President Bush signed the financial bailout bill into law on Friday.

The Fed's action reversed its current policy on interest rates, which had been to hold them steady out of concern that more cuts would fuel inflation. Since Fed Chairman Ben Bernanke and his colleagues put a stop to interest-rate cuts in June, economic and financial conditions have deteriorated significantly.

"The pace of economic activity has slowed markedly in recent months," the Fed said. "Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit."

Although inflation has been high, the Fed believes the recent drop in energy prices and the weaker prospects for economic activity have reduced this threat to the economy.

The orchestrated rate reductions had a mixed impact on stressed credit markets. Rates dipped on some commercial paper, a crucial short-term financing mechanism that many businesses rely on to bankroll day-to-day operations. The important "Libor" rate, which affects a vast array of loans, remained high, however.

The Fed also reduced its emergency lending rate to banks by half a percentage point to 1.75 percent. Given the intense credit crisis, banks have been ramping up their borrowing from the Fed's emergency "discount" window.

The fact that the Fed felt it couldn't wait until its regularly scheduled meeting on Oct. 28-29, underscored the urgency of the situation.

One of the goals of the coordinated rate cuts is to spur nervous consumers and businesses to spend more freely again. They clamped down as housing, credit and financial problems intensified last month, throwing Wall Street into chaos. Many believe the United States is on the brink of, or already in, its first recession since 2001, one that could quickly spread to other countries around the globe.

It can take months before rate cuts work their way through the financial system, however, and the economy has pressing problems now. Major U.S. retailers turned in dismal reports of third quarter sales, a dire omen for the all-important holiday shopping season. Consumer spending accounts for more than two-thirds of the nation's economic activity.

The Fed's last rate cut was in late April, capping one of the most aggressive rate-cutting campaigns in decades as it scrambled to shore up the faltering economy. After that, the Fed moved to the sidelines, holding rates steady as zooming food and energy prices during that period threatened to ignite inflation. In the past few months, energy prices have retreated from record highs reached in mid-July, giving the Fed more leeway to drop rates again.

At its last meeting in September, the Fed struck a more dire tone about the economy, hinting that a rate reduction once again could be in the offing.

Even with the unprecedented $700 billion financial bailout plan, the failing economy and the jobs market probably will get worse. Many believe the economy will jolt into reverse later this year -- if it hasn't already-- and will stay sickly well into next year.

Mounting job losses, shrinking paychecks, shriveling nest eggs and rising foreclosures all have weighed heavily on American voters, who will be electing a new president in about four weeks. The economy is their No. 1 concern, polls have shown.


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