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Fed's Surprise Rate Cut Draws Mixed Response

The Federal Reserve's emergency rate cut on Tuesday drew a mixed response on Wall Street, though the move increased the odds of more reductions, including a possible half-point cut at next week's regular policy meeting.

Federal Reserve Bank Chairman Ben Bernanke
Ted S. Warren
Federal Reserve Bank Chairman Ben Bernanke

The Fed on slashed a key interest rate by a hefty three-quarters of a percentage point, the biggest cut in more than 23 years, after a two-day global stocks rout sparked by fears of a U.S. recession.

The move, a rare one made between the U.S. central bank's regularly scheduled meetings, took the federal funds rate governing overnight lending between banks down to 3.5 percent, its lowest level since September 2005. The Fed also lowered the discount rate it charges on direct loans to banks to 4 percent.

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"The Fed is very, very, very worried," said John Tierney, an analyst at Deutsche Bank in New York.

The Fed's bold bid failed to instill confidence in shaken financial markets as U.S. stocks, playing catch-up with sell-offs around the world, fell sharply at the open. But stocks trimmed most of their losses to close with relatively minor declines.

Prices for U.S. government bonds slipped, while the dollar fell sharply against the euro.

"The committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth," the Fed said, referring to its policy-setting Federal Open Market Committee.

"While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households," it said.

February fed funds futures indicated a 90% chance that the Fed will lower its target for overnight rates to 3% from 3.5% at its next policy setting meeting on Jan. 30.

Some analysts viewed the Fed's surprise move, which came just a week ahead of its next regularly scheduled meeting on Jan. 29-30, as a timely and much-needed effort to shore-up deteriorating confidence in global markets. Others said it signaled a sense of desperation.

"Plainly the Fed realized that to try to stay ahead of the market they had to act immediately. That is the positive reading of the action," said Alan Ruskin, chief international strategist at RBS Greenwich Capital in Greenwich, Connecticut. "The negative viewpoint is that it smacks of panic."

Shortly after the Fed announced it was lowering U.S. interest rates, the Bank of Canada cut its key overnight interest rate by a quarter percentage point to 4 percent and said further cuts were likely to be needed.

Even after the Fed's move, interest-rate futures markets showed a 74 percent chance of another half-percentage point reduction in U.S. rates next week. They also pointed to a federal funds rate of 2.25 percent by mid-year.

The Fed rarely lowers borrowing costs in between scheduled meetings, but stock markets around the globe had sold off heavily this week, posing another challenge to an economy already struggling under the weight of a deep housing slump and tight credit conditions.

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"Appreciable downside risks to growth remain," the Fed said, adding that it would "continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks."

The central bank said incoming data "indicates a deepening of the housing contraction as well as some softening in labor markets".

The rate cut was the first in between regularly scheduled Fed meetings since Sept. 17, 2001, the first day U.S. financial markets reopened after the Sept. 11 terror attacks.

The last time the Fed took actions that reduced the federal funds rate by at least three-quarters of a point was in October 1984. However, it only began to set an explicit federal funds rate target as its primary lever to influence the economy around 1990.

Prior to that, it had used the discount rate to signal its policy stance. It had cut the discount rate by a full point in December 1991.

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