Fed slashes short-term interest rates

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Call it the Xanax rate cut, after the anti-anxiety drug.

To soothe the jitters of consumers and businesses who are worried that the economy is stalling, the Federal Reserve’s rate-setting body dispensed a little pill in the form of a half-point reduction in the overnight lending rate, from 1.75 percent to 1.25 percent.

The rate cut was expected, but most observers were betting on a quarter-point drop.

“The Committee continues to believe that an accommodative stance of monetary policy, coupled with still-robust underlying growth in productivity, is providing important ongoing support to economic activity,” the Federal Open Market Committee announced. “However, incoming economic data have tended to confirm that greater uncertainty, in part attributable to heightened geopolitical risks, is currently inhibiting spending, production, and employment. Inflation and inflation expectations remain well contained.

“In these circumstances, the Committee believes that today’s additional monetary easing should prove helpful as the economy works its way through this current soft spot.”

Most consumers will realize little, if any, savings in their monthly bills because of the rate reduction, but this Fed action is more of a mind game than a monetary move.

“They’re surrendering to the pop psychologists,” says William Dunkelberg, professor of economics at Temple University. It’s as if the Fed is saying, “We’ll make you feel better. We’ll cut it,” he adds.

The Fed, says economist Richard DeKaser, is trying to “demonstrate some support to the economy, as Greenspan has done in the past, at a moment of market anxiety.” DeKaser, chief economist for National City Corp., disagrees with the wisdom of the Fed’s action — he believes it should have left rates alone — but he adds, “I think it will have some confidence-inspiring effect.”

The rate-setting Federal Open Market Committee believed that consumers, investors and businesses needed this dose of confidence “as the economy works its way through this current soft spot.” That implied that the Fed believes today’s economic doldrums are temporary. The committee also hinted that this is the last rate cut it envisions making, as it concluded that the risk between inflation and economic slowdown are balanced. At the last meeting, the Fed had said there was more of a risk of an economic slowdown.

Although a rate cut is designed to stimulate the economy by making it cheaper to borrow money, hardly anyone attributes the weakness in today’s economy to high interest rates. Concern over Iraq, companies’ reluctance to hire new employees, and consumers’ nervousness about the job market seem to be the big problems.

The overnight rate, officially called the federal funds rate, is what banks charge one another to cover reserves. The Fed sets a target for the overnight rate and controls it indirectly by adding and subtracting cash from the banking system.

The Fed’s actions affect consumers because the overnight rate influences the prime rate, which is what banks charge their best corporate customers. Some types of consumer debt are based upon the prime rate. Many variable-rate credit cards, car loans and home equity lines of credit are tied to the prime rate.

The prime rate will drop to 4.25 percent. Rates on some home equity loans and home equity lines of credit will drop, too. Rates on some variable-rate credit cards could drop, but many of those cards have minimum rates that they hit a year ago, and they won’t go lower, regardless of the lower prime rate. Rates on some car loans will drop, but people with excellent credit have been eligible for zero-percent loans for more than a year.

Rates for 15-year and 30-year mortgages tend to move independently of the Fed’s rate actions. Instead, long-term mortgage rates roughly follow yields on 10-year Treasury notes, which have hovered within a half-point above and below 4.1 percent since July.

Economists believe last week’s unemployment report made the rate cut almost inevitable. The October jobless rate rose to 5.7 percent from 5.6 percent in September. The overall number of jobs decreased by 5,000 in October, after decreasing 13,000 in September.

Those data supplemented other poor news: An index of the manufacturing sector indicated the first contraction in eight months. Consumer confidence dropped. War talk worried people.

On the other hand, the economy grew by 3.1 percent from July through September, and a key index of services showed unexpected strength.

Few saw this rate cut coming a few months ago, when it looked like the economy was poised for a vigorous recovery from last year’s recession, and people debated about the timing of the inevitable rate increases. Then, in summer, the economy started showing a few signs of malaise — nothing too serious, but enough to warrant watching. When the Federal Open Market Committee met in August, it issued a statement saying that “the risks are weighted mainly toward conditions that may generate economic weakness.” That was a sign that the Fed was more likely to cut rates again rather than raising them.

The Fed reduced the overnight rate 11 times in 2001, from 6.5 percent at the beginning of the year to 1.75 percent at year’s end. When it made the first cut, on Jan. 3, the economy wasn’t yet in recession; at the last cut, on Dec. 11, the economy was on its way out of a shallow recession.

It looked for most of 2002 that the rate-cutting era was over. Then came this anxiety-reducing rate cut. Dunkelberg wonders what the point of the rate cut is. “It’s certainly not going to do anything for the real economy right now,” he says, noting that it takes 12 to 18 months for Fed rate cuts to be fully felt. “Interest rates are at 40-year lows. What more can you ask?”

He worries that a rate cut “acknowledges weakness. That can scare everybody.”

— Posted: Nov. 6, 2002