By Jason Simpkins
The U.S. Federal Reserve cut its key interest rate by a quarter percentage point to 4.25% yesterday (Tuesday), the third time the central bank has reduced borrowing costs since mid-September.
At its highly anticipated Dec. 11 meeting, the Federal Open Market Committee elected to reduce the Federal Discount Rate, the rate at which banks borrow money directly from the central bank, by a quarter point as well.
"Recent developments, including the deterioration of in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation," the Fed said in its statement. It added that this action "should help promote moderate growth over time."
The financial markets reacted badly to the rate cut - recording their biggest declines in a month as investors worried the rate cut wasn't enough to stave off a U.S. recession. The Dow Jones Industrial Average plunged 294.26 points, or 2.14%, to close at 13,432.77. The much-broader Standard & Poor's 500 Index fell 38.31 points, or 2.53%, to close at 1,477.65. The tech-laden Nasdaq Composite Index skidded 66.60 points, or 2.45%, to close at 2,652.35.
Commercial banks quickly began to match the latest rate reduction by cutting their prime lending rates for consumer and business loans to 7.25%. Bank of America Corp. (BAC) and Wachovia Corp. (WB) were among the first to do so. The prime rate is what banks charge their best customers. It serves as the benchmark for lending rates to customers for mortgages and credit cards.
Policymakers Closely Watched
At the highly anticipated meeting yesterday, the policymaking Federal Open Market Committee (FOMC) also announced a quarter-point cut in the Discount Rate, the rate at which banks borrow money directly from the central bank.
Many economists had expected the quarter-point Fed Funds rate reduction, the third such cut in as many meetings for the committee. The FOMC has clearly chosen a gradual approach to the reduction of interest rates, as a means of returning market stability and buoying an economy beleaguered by subprime mortgage defaults, declining home values, and tighter lending conditions.
Central bank Chairman Ben S. Bernanke and the Federal Reserve held fast this summer when the housing market first showed signs of weakness, and the asset-backed debt market began to fold. They have shown similar restraint so far, issuing two consecutive quarter-point reductions after slashing the key interest rate by half a point in September.
Inflationary forces have had as much influence over the Fed's decision-making as caution has itself. The U.S. dollar has been in a freefall, having dropped 20% against a basket of major currencies this year, and 44% against the euro since 2000. As a result, the price of oil climbed to a record high $99.29 a barrel on the New York Mercantile Exchange last month, spurring on higher energy costs.
Regardless, most analysts believe the Federal Reserve will have to continue slashing rates if it hopes to stave off a recession.
"Whether it be consumer confidence, or real incomes, or business plans, we're seeing an economy that is continually slipping and therefore an increasing probability of a recession next year," Martin Feldstein, an economist at Harvard University, told Bloomberg News last week. "The Fed has to be prepared to continue cutting rates as we go into 2008."
Heavy losses in the housing sector have contributed to the mounting pessimism about the greater U.S. economy. According to the Mortgage Bankers Association, the number of Americans who fell behind on their mortgage payments in the third quarter rose to a seasonally adjusted 5.6%, the highest in two decades. New foreclosures also reached a record high.
As a result banks have tightened their lending standards and may continue to do so as a means of preserving capital. A Fed study in October showed 40% of lenders have raised their standards to qualify for prime loans, which are loans offered to the most credit-worthy applicants.
News and Related Story Links:
- Money Morning:
Solid Jobs Report, Subprime Bailout Plan Position Federal Reserve Policymakers For Rate Cut Today
BofA, Wachovia lower prime-lending rate.
- Bloomberg News:
U.S. Stocks Fall After Fed Cuts Benchmark Rate by Quarter Point.]