By William Patalon III
Money Morning/The Money Map Report
Faced with plunging markets abroad and intensifying recession fears here at home, the U.S. Federal Reserve yesterday (Tuesday) slashed its benchmark interest rate by three quarters of a percentage point, its single-biggest reduction in nearly 25 years.
In a related development yesterday, the Bush Administration left open the door for an economic stimulus package even larger than the $150 billion fiscal-stimulus plan the President outlined last week. That plan – equal to about 1% of U.S. Gross Domestic Product – may include tax rebates to low- and middle-income families, and tax breaks for businesses.
But it was the early morning move by the Fed yesterday that caught investors by surprise, since it preceded the central bank's regularly scheduled policymaking move by a week. The move took the crucial Federal Funds Rate down to 3.50% from 4.25%. The central bank also cut the Discount Rate by a similar amount, taking it down to 4%.
The Fed Funds Rate is what banks charge one another for overnight loans. It also serves as a benchmark for the Prime Rate, the base rate that banks use to price loans to their best and most credit-worthy customers.
"This is not likely to be the last rate cut, but it at least gets the Fed off the brake and onto the accelerator," said Joel Naroff, chief economist for Naroff Economic Advisors in Holland, Pa. "Recent economic [reports] do not indicate we are currently in a recession, but the threats are clear and the problems in the credit markets persist. Thus, the probability of a recession remains high."
The central bank rate cut came one day after foreign markets throughout both Asia and Europe were routed by investors who are betting that a U .S. recession will cause global growth to sputter and slow – or even stall altogether.
On Monday, the MSCI World Index careened downward 3%, the steepest drop since 2002. Benchmark indices in 38 countries – including France, Italy and Mexico – were at least 20% off their highs, putting them in bear-market territory. Declines in India, Indonesia, the Philippines, Taiwan and Thailand joined their bearish brethren with sell-offs today, Bloomberg News reported.
Making matters even worse was the fact that U.S. markets were closed for the Martin Luther King holiday, meaning U.S. investors could only watch as those overseas indices plunged.
It was the first time since Sept. 17, 2001 that the policymaking Federal Open Market Committee (FOMC) had changed the Fed Funds target rate outside of a regularly scheduled meeting. The FOMC is next set to meet on Jan. 29 and 30. A few market mavens are expecting another rate cut – possibly as much as a half a point – at that meeting, though most economists dismissed that possibility.
The three-quarter-point cut was the biggest cut in the Fed Funds rate since October 1984.
The size, surprise nature and timing of the rate-reduction announcement – and the fact that it came between policymaking meetings – lent it an air of desperation. And investors reacted.
The Dow Jones Industrial Average fell nearly 465 points in early trading, before the blue-chip bellwether changed direction and eradicated much of the loss. The Dow closed at 11,634.82, down 128.11 points, or 1.06%. It's down 16.2% from the record high levels it achieved last year.
In announcing the rate cut, the Fed's policymaking arm said it "took this action in view of a weakening of the economic outlook and increasing downside risks to growth. 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."
On Jan. 10, Fed Chairman Ben S. Bernanke signaled the central bank's willingness to act aggressively when he said it would "remain exceptionally alert and flexible," and noted it was ready "to take substantive additional action as needed to support growth."
Analysts and economists had mixed views of the rate-reduction plan.
Marc Ostwald, a market strategist at Insinger de Beaufort, said the size and timing of the interest-rate move "smacks of panic."
It all "sends a very poor signal," Ostwald told Great Britain's Guardian newspaper. "The impression is reinforced by the fact that this is the first 75 basis points cut since the early 1980s, when interest rates were in [the] double digits."
However, Morgan Stanley (MS) Global Wealth Management Strategist Kevin Flanagan said that the early move by the U.S. central bank is likely to bring calm to the markets.
And Eaton Vance Corp. (EV) Economist Bob Macintosh told the Guardian that the rate cut was "more of a psychological move than anything else with the Fed clearly trying to tell us that they are giving us a hug. It should help turn things around. Let's see."
One big concern is that the rate cut could cause already spiraling inflationary pressures to build up even more by exacerbating the ongoing slide in the U.S. dollar. By cutting rates here at home, other economies will have an even greater relative advantage when it comes to their market interest rates. Because their rates are higher, those markets will be better positioned to attract foreign investment capital that's looking for a home. Some of that capital will be pulled out of U.S. investments, further reducing the demand for greenbacks, and causing the dollar to skid against other currencies.
However, some economists now believe that the severity of the U.S. rate cut and the turbulence in the global markets will force central bankers overseas to cut rates to keep the U.S. financial miasma from further infecting their economies. That could steady the dollar – not a bad development for U.S. investors [For a related story on a rate-cut move engineered by the Bank of Canada – and the affect it had – please click here].
The Bush Administration bailout plan will also play a role – though not all agree that role will be positive.
U.S. Treasury Secretary Henry Paulson praised the U.S. central bank, and called upon Congress to "quickly enact" legislation to add muscle to the U.S. economy's growth.
"Time is of the essence and the President stands ready to work on a bipartisan basis to enact economic-growth legislation as soon as possible," Paulson told members of the U.S. Chamber of Commerce in a scheduled address to that business group yesterday.
Paulson underscored the administration's belief that the U.S. economy and its housing market is still working its way through a "significant correction," and noted that growth has "materially" slowed in the last couple of weeks.
The Bush Administration said it's studying other ways to stimulate growth beyond the anti-recession plan it detailed last week.
The growth package centers on tax cuts, but sources told The Associated Press that it also includes rebates of between $800 and $1,600 for individual taxpayers and couples, and so-called "bonus depreciation" to allow companies to deduct half of all investments they make this year.
News and Related Story Links:
- Bloomberg News:
Paulson Praises Fed Cut, Says Stimulus Plan Needed
- Guardian Unlimited:
U.S. Rate Cut: What the Economists Say
- The Associated Press:
About the Author
Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning. With his latest project, Private Briefing, Bill takes you "behind the scenes" of his established investment news website for a closer look at the action. Members get all the expert analysis and exclusive scoops he can't publish... and some of the most valuable picks that turn up in Bill's closed-door sessions with editors and experts.