Fed cuts rates by 50 basis points

At Bankrate we strive to help you make smarter financial decisions. While we adhere to strict , this post may contain references to products from our partners. Here’s an explanation for

A committee of the Federal Reserve has cut the short-term interest rate by half a percentage point, to the lowest it’s been since the Berlin Wall was under construction.

The Federal Open Market Committee reduced the overnight lending rate from 2.5 percent to 2 percent, as expected. That’s the lowest it has been since September 1961, a few weeks after East Germany started building a concrete wall around West Berlin.

The prime rate, which is the interest rate that banks charge their best customers, is expected to fall immediately to 5 percent in response to the Fed’s action. The last time the prime rate was 5 percent was May 1972.

“Heightened uncertainty and concerns about a deterioration in business conditions both here and abroad are damping economic activity,” the Federal Open Market Committee says. “For the foreseeable future, then, the Committee continues to believe that, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness.”

The Fed has cut rates aggressively because the economy showed signs of slowing down all year, and lower interest rates stimulate the economy. But the Fed can’t repeal the business cycle. The nation’s output of goods and services shrank 0.3 percent in the third quarter of this year. The same is expected to happen in the fourth quarter, and that would meet the popular definition of a recession.

Many economists believe that the economy would have gone into recession anyway, but the terrorist attacks of Sept. 11 accelerated the decline. People stopped traveling and factories had to shut down because shipments of parts and materials were stuck in warehouses or held up at borders.

More misery
Unemployment climbed to 5.4 percent in October (a five-year high) and payrolls were slashed by 415,000. Retailers say they expect lousy holiday sales. Consumer confidence has plummeted.

With these problems, the Fed’s mission is to stanch the loss of jobs and persuade consumers to buy again. Not everyone is sure that the rate cuts will do the trick.

The loss of more than 400,000 jobs means that the Fed is “forced to make a statement,” says Joel Naroff, an economist and president of Naroff Economic Advisors. With the movement from 2.5 to 2 percent, “there isn’t a lot more that the Fed can do in terms of affecting the economy.”

The problem isn’t that people can’t afford to buy because of high interest rates; rather, the problem is that people fear terrorism and the loss of their jobs, Naroff says.

“Right now we are in one of those classic circumstances where traditional Keynesian economics is the right prescription,” Naroff continues. “The problem is lack of demand.”

According to traditional Keynesian economics, the way to break out of a recession is for the government to spend more money than it has. That employs people and stimulates demand. Keynesian economics is out of fashion, though; policymakers listen more to supply-siders who tout the benefits of low taxes and minimal government spending.

Greg Mount, senior economist for Bank One, says the Fed still has room to stimulate the economy with interest rate cuts, even after reducing the rate to just 2 percent. “Some say they don’t have many bullets left in their gun, and that’s an erroneous assumption,” Mount says. “The last time rates were this low, the economy was on its way back up.”

Fed rate actions affect short-term interest rates directly and long-term rates, such as those for mortgages, indirectly. Mount says the Fed’s action could give mortgage rates more room to fall.

“With inflation a dead horse now, you still have room for mortgage rates to fall further and that definitely puts more money in people’s pockets,” he says.

Many economists share Mount’s cautious optimism. They believe that the economy is in the midst of a short, mild recession, and that the Fed’s rate-cutting actions this year averted a longer, deeper recession.

David Orr, chief economist for Wachovia Securities, had predicted last week that the Fed would cut the overnight rate by half a percentage point because it would rather overreact than underreact.

The Fed’s policy, Orr says, is “to act such that if it makes a mistake, that mistake would do the least harm. Given this week’s data, along with lower inflation and less worry about long-term rates, easing too much seems less likely to hurt the economy than easing too little.”

He notes that the futures market believes there’s a 50 percent chance that the overnight lending rate will drop to 1.75 percent early next year.

And Geoffrey S. Somes, senior economist for FleetBoston Financial, takes solace that, “although surely fretting over the short-term contraction in the U.S. economy, at every opportunity Fed Chairman Alan Greenspan talks up its still favorable long-term prospects.”

— Posted: Nov. 6, 2001