Fed Surprises Investors With Steep Rate Cuts

The Federal Reserve cut two key interest rates by half a point, seeking to prevent a steep housing slump and turbulent financial markets from triggering a recession.

The Fed announced Tuesday that it was reducing its target for the federal funds rate, the interest that banks charge each other, from 5.25% to 4.75%. The half-point reduction was double the quarter-point move that many economists had been expecting.

Ben Bernanke, President Bush's top economic adviser, speaks in the Oval Office at the White House after Bush named him to take over the Federal Reserve from retiring Alan Greenspan, in Washington, Monday, Oct. 24, 2005. It was the third time in as many years the president has turned to the 51-year-old Bernanke for a sensitive post. Bush named him to the Fed board in 2002, then made him chairman of the president's Council of Economic Advisers earlier this year. (AP Photo/J. Scott Applewhite)
J. Scott Applewhite

The central bank also reduced its discount rate, the interest it charges in making direct loans to banks, by a half-point as well. The Fed already had cut the discount rate on Aug. 17 as it scrambled to respond to the growing credit crisis.

Stocks immediately rallied on the moves, which were more aggressive than many investors had expected.

The action was designed to boost economic growth by lowering borrowing costs for millions of consumers and businesses. Commercial banks were expected to quickly match the Fed's action by cutting their prime lending rate. The prime rate has been at 8.25 percent for the past 15 months.

The Fed's action came in the midst of the worst slump in housing in 16 years. That downturn has triggered record defaults in subprime mortgages and roiled financial markets around the globe as investors have become worried about where the spreading credit problems will next appear.

The financial market turmoil represents the first major test for Fed Chairman Ben Bernanke, who took over from the venerable Alan Greenspan in February 2006.

Tightening Credit

In explaining its action Tuesday, the Fed said that "the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally."

Did the Fed Get it Right?

Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time," the Fed said in a statement outlining its decision.

The central bank said that it still believed the economy faced some risk of inflation, but said that financial market developments since its last meeting in early August had increased the uncertainty surrounding the economic outlook.

"The committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth," it said.

The decision comes as evidence accumulates that a prolonged U.S. housing market downturn and a wild financial market ride over the summer has taken a toll on broader economic activity.

A decline in employment in August, the first drop in four years, appeared to confirm that housing-related strains were weighing on businesses and impacting households.

In addition, reports on retail sales and industrial output in August also showed some softness.

Change in August

At its last regularly scheduled meeting on August 7, the U.S. central bank had said its predominant concern was inflation, even as it noted tighter credit and financial market volatility.

Within days of the Fed's August 7 meeting, financial markets unraveled as French bank BNP Paribas froze three funds with U.S. subprime mortgage market exposure. The Fed on August 10 said it would pump cash into the banking system as necessary to keep markets functioning normally.

Even so, stock markets tumbled the following week, at one point plumbing declines of more than 10 percent below 52-week highs before rebounding.

The U.S. central bank then stepped in on August 17 with a surprise cut to the discount rate and an explicit acknowledgment that risks to growth had "increased appreciably."

Further seeking to sooth markets, Fed Chairman Ben Bernanke addressed the turmoil directly in a speech on August 31. His comments that the Fed stood ready not only to provide liquidity but to limit adverse impacts to the economy seemed to seal the prospect of a cut to the more-important federal funds rate.