The Federal Reserve took the rare action of slashing short-term interest rates between scheduled meetings in response to a global meltdown in financial markets.
The Fed cut the target for the federal funds rate by a hefty three-quarters of a percentage point, to 3.5 percent. The prime rate will fall by three-quarters of a point, too, to 6.5 percent. Over the coming weeks and months, interest rates will fall on home equity lines of credit and many variable-rate credit cards. Yields on shorter-term certificates of deposit are likely to fall.
It’s too soon to say how the Fed rate cut will affect fixed- and adjustable-rate mortgages and auto loans. Those types of loans are only indirectly affected by the rates that the Fed controls. But when the Fed does something unexpected, it can create an impact.
“The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth,” the Fed said in a statement. “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. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.”
The central bank went on to say that “downside risks to growth remain,” and that inflation is expected to moderate over the next few months, although prices merit close watching.
This action comes as stock indexes are plunging across the globe. Stock indexes in Hong Kong, Japan, India and South Korea fell at least 3 percent Monday. British, French and German stock indexes fell at least 5.5 percent. Canadian, Brazilian and Mexican stock indexes fell at least 4.75 percent.
The move by the Fed’s Open Market Committee came as a minor surprise because it occurred between the central bank’s regularly scheduled meetings. In the last week, as the dollar continued to weaken, stock prices fell, and more and more economists said a recession is imminent, observers began to speculate that the Fed would cut rates before its next scheduled meeting, on Jan. 29 and Jan. 30.
The vote was not unanimous among the 10-member Federal Open Market Committee that sets rates. Eight members voted for the rate cut. William Poole, president of the Federal Reserve Bank of St. Louis, voted against the cut. The Fed said that Poole “did not believe that current conditions justified policy action before the regularly scheduled meeting next week.” Frederic Mishkin, a member of the Fed’s board of governors, was absent and did not vote.
The last time the committee made a surprise rate cut was Sept. 17, 2001, six days after the terrorist attacks. Back then, the Fed was reacting to a lack of cash in financial markets. This time, the Fed was responding to anxiety about tight credit brought on by unexpectedly high defaults in some types of mortgages. The problems in the mortgage business spread into other credit markets, affecting the availability of money for private equity firms that borrow huge sums to buy publicly traded companies. Some hedge funds posted gigantic losses because of mortgage-related problems. The pain was felt globally, and not just in the United States.
The federal funds rate is the target interest rate for banks borrowing reserves among themselves. The discount rate is the interest rate that the Fed charges banks to borrow reserves from the Federal Reserve. The Fed wants to be the lender of last resort: It wants banks to borrow from one another at the federal funds rate before borrowing from the Federal Reserve at the lower discount rate.