The U.S. Federal Reserve on Tuesday began its first easing cycle in more than four years with an aggressive half-percentage-point reduction in the federal-funds rate to combat the effects of a housing recession and credit crunch on the broader economy.
Its willingness to move aggressively and pledge to "act as needed" to foster growth and price stability, despite scant evidence so far of a sharp slowdown, fueled hopes for more rate reductions in coming months. The Federal Open Market Committee voted unanimously to cut the fed-funds rate, the rate at which banks lend to each other, to 4.75% from 5.25%. It had stood at 5.25% for more than a year. The decision surprised many on Wall Street who expected a more modest reduction. In a Dow Jones Newswires poll taken last week, 11 primary dealer banks said they only expected a quarter-percentage-point cut, while seven forecast a half-percentage-point reduction. The Fed also lowered the discount rate it charges banks that borrow directly from the central bank by 50 basis points, to 5.25%. Last month, officials cut the discount rate by 50 basis points in a rare intermeeting move and modified rules to encourage use of that facility. "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 an accompanying statement. The rate cuts "tell you something about the (Fed Chairman Ben) Bernanke reaction function," said Stephen Stanley, chief economist at RBS Greenwich Capital Markets. "They're clearly aggressive." Stocks soared on the Fed's decision, while the dollar, whose value depends in part on rate differentials with other currencies, fell. Longer-dated Treasurys prices, which are sensitive to inflation expectations, fell. Short-dated Treasurys that are affected by monetary policy expectations rose in price. The Fed also said core inflation has improved "modestly" but that some risks remain and that it will monitor price developments "carefully." It didn't cite any specific price risks, though. In a departure from previous statements, the Fed didn't refer to high capacity utilization, a nod to tight labor markets, as an inflation risk. Inflation "is not a believable risk to the forecast" given the size of the rate cut, said Chris Rupkey, economist at Bank of Tokyo-Mitsubishi. | |
| Door Open For Further Rate Cuts | |
In a sign of just how quickly the economic outlook has changed, as recently as the Fed's Aug. 7 policy meeting it still had an inflationary bias, suggesting it saw no need for lower rates six weeks ago. The Fed didn't refer to a balance of risks between economic growth and inflation in Tuesday's statement, which some economists took as a sign that future rate cuts aren't a lock. But the Fed's worry seems clearly centered on the economy. "Although the magnitude of rate cuts is likely to be smaller going forward, the Fed left the door open for more cuts," said Tony Crescenzi, strategist at Miller Tabak, in a research note. The last time the Fed cut the fed funds rate was June 2003, a 25-basis-point cut that capped a two-and-a-half year easing cycle that brought the fed-funds rate from 6.5% to a five-decade low of 1%. Prior to Tuesday, it hadn't cut by 50 basis points since November 2002. The aggressive move Tuesday suggests officials are worried about potential spillovers from housing and credit conditions on the overall economy, even though evidence of a big effect has been limited thus far. The economy has slowed, but there is no concrete evidence that it is near recession, and economic growth forecasts remain centered in the 2% to 2.5% range. Housing remains a big negative that will likely get worse. But international trade is a sizable plus, judging by the July trade report. And though retail sales were below expectations last month, the consumer seems to be holding up so far. But officials signaled worry nonetheless. "Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally," the Fed said. Officials may have been spooked by last month's 4,000 decline in nonfarm payrolls, which was the first in four years and the catalyst that had pushed many Fed watchers into the 50-basis-point camp. Fed watchers had also interpreted recent comments by Fed Governor Frederic Mishkin and San Francisco Fed President Janet Yellen as making the case for an aggressive start to the easing cycle. But other officials, including Thomas Hoenig of Kansas City and Richard Fisher of Dallas, have alluded to the economy's bright spots, suggesting they would have been wary of cutting rates aggressively. Hoenig and Fisher are nonvoting FOMC members this year, as is perhaps the Fed's most hawkish member when it comes to controlling inflation, Richmond Fed President Jeffrey Lacker. Richmond and Atlanta weren't among the district banks requesting a half-point discount rate cut, according to the Fed statement, though Kansas City did request it along with Boston, New York, Cleveland, St. Louis, Minneapolis and San Francisco. Mishkin may now find his words even more carefully scrutinized by Wall Street for rate clues. Last week, he referred to "important" downside economic growth risks. And in a paper presented earlier this month at the annual Jackson Hole seminar, Mishkin discussed a scenario in which a central bank cuts the fed funds rate "more aggressively and substantially faster" in response to a home-price decline than it would under traditional models. Tuesday's aggressive Fed move "raises Mishkin's profile, which was already pretty high," said Drew Matus, economist at Lehman Brothers. | |
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