By Jason Simpkins
Federal Reserve policymakers yesterday (Wednesday) reduced the benchmark Federal Funds rate to 1.0%, an aggressive half-percentage-point cut that central bank Chairman Ben S. Bernanke's latest attempt to keep the widening financial crisis from tipping the world into a global recession.
"The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures," the Fed said in a statement. "Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports.
"Moreover," the statement added, "the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit."
The Fed also lowered its discount rate – the rate at which it lends directly to banks and Wall Street firms – by a half-percentage point to 1.25%.
A wave of failures among banks and financial institutions have stymied lending and roiled global credit markets. The world economy faces a significant uphill battle as a result.
The U.S. economy expanded by 2.8% in the second quarter, but that expansion was largely the product of government stimulus checks and a weak dollar. The federal government returned roughly $168 billion back to American taxpayers in the form of rebate checks earlier this year. The tax rebates, which were mailed through May, kept U.S. consumers afloat, while a weak dollar accelerated a torrent of exports out of the country.
Since then, consumer spending has been undermined by rising unemployment and the dollar has strengthened substantially. The advance estimate for third quarter gross domestic product (GDP) is to be released today (Thursday), and most analysts anticipate the U.S. economy shrunk during the three months ended Sept. 30.
"The growing reality is that this is not just a slowdown, but a true recession," Joel Naroff, president and chief economist of Naroff Economic Advisors said in an interview with Money Morning.
"U.S. GDP contracted significantly in the third quarter," said Naroff, who believes the economy may have contracted by 2.5% to 3.0% in the quarter. "Such a sharp slowdown is not expected."
Citigroup Inc. (C) analysts Geoffrey Dennis and Jason Press said last week that they now expect an entire year of contraction before the economy gets back on track in the second half of 2009.
"We are now expecting one of the sharpest recessions in the post-war period," Dennis and Press wrote in a report to clients on Oct. 21.
The Fed statement said the rate cut "should help over time to improve credit conditions and promote a return to moderate economic growth," but noted "downside risks to growth remain."
This is the ninth time that the central bank has lowered rates since September 2007.
The Fed has also loaned hundreds of billions of dollars to banks through a new lending program and earlier this week began loaning money directly to major businesses by purchasing commercial paper.
The Fed yesterday lowered the interest rates it will charge to buy unsecured commercial paper to 1.84%, down from 1.89% on Tuesday. It lowered the interest rate on asset-backed commercial paper to 3.84% yesterday, down from 3.89% the day prior.
The central bank created its program to buy 90-day commercial paper directly from issuers on Oct. 7, meaning it's now three weeks old.
The Fed's new loan programs have expanded assets on its balance sheet by 104% during the past year to $1.804 trillion, or 12.6% of GDP, Bloomberg reported.
Rate Reductions Around the World
While the Federal Reserve struggles to keep the U.S. economy from sinking into a second Great Depression, central banks in Europe and Asia are also on the defensive and could soon join the Fed in slashing rates – if they haven't already.
The British Office for National Statistics last week said that, after a flat second quarter, the U.K. economy contracted 0.5% in the three months ended Sept. 30. It's likely that Germany, France and Italy have already entered into a recession, as their second-quarter GDP fell 0.5%, 0.3% and 0.3%, respectively.
The International Monetary Fund (IMF) said last week that the economy of the 15-country Eurozone would grind to a virtual standstill in 2009.
The European Central Bank (ECB), which raised rates as recently as July, backtracked and cut its benchmark rate by half a point on Oct. 8, dropping it down to 3.75%. ECB President Jean-Claude Trichet said Monday that the central bank's Governing Council could take additional steps at its next meeting, currently scheduled for Nov. 6.
"I consider it possible that the Governing Council would decrease interest rates once again at its next meeting," ECB President Jean-Claude Trichet said yesterday. "Taking into account the recent substantial decline in commodity prices together with a substantial weakening in demand which has emerged lately, upside risks to price stability have diminished."
Nick Parsons, head of markets strategy at nabCapital (OTC: NABZY) in London, told The Guardian that the Bank of England (BOE) could also follow the Fed's move with a one-point cut of its own. That would leave the BOE's rate at 4.5%
China, on the other hand, wasted no time in following the lead of the U.S. Fed. The People's Bank of China cut its interest rates yesterday, reducing its key one-year lending rate from 6.93% down to 6.66%. The rate cut was the central bank's third reduction in two months.
China's economy registered a solid GDP expansion of 9% in the third quarter – a noticeable step down from the 11.9% pace set in 2007. Beijing is clearly worried about the effects a global recession would have on its economy and wants to ensure growth does not slow any further.
Of course, lowering rates will also help keep the Chinese currency, the yuan, from appreciating against the dollar and the euro as central banks in the West pull out all the stops in dealing with the credit crisis.
"This cut was driven by the slowdown in the third quarter and the likelihood that the U.S. and other central banks will cut rates," Xing Ziqiang, an economist at China International Capital Corp. in Beijing, told Bloomberg.
GDP growth in China has slowed for the past five quarters but so long as the nation keeps inflation in check it should be able to maintain a "reasonable" economic expansion of at least 8% next year, said Liu Erh-fei, managing director and chairman for China at Merrill Lynch & Co. Inc. (MER).
Whether Chinese banks were "wise, lucky, or better regulated," they avoided exposure to the risky subprime mortgages and derivative products that caused the current financial firestorm," said Liu. "There is no systemic risk in China's banks that could spill over into a full blown financial crisis."
China has more than enough economic weapons at its disposal to ensure strong growth going forward, including a world-leading $1.9 trillion in foreign currency reserves. China also has a budget surplus of 2% of GDP, according to Stephen Green, of Standard Chartered PLC. And public sector debt is just 16% of GDP.
Earlier this year, Beijing shifted the focus of its policy to growth rather than inflation – a choice analysts say is now paying dividends.
Inflation in China, and worldwide, is beginning to ease alongside commodities prices. Inflation in China receded to 4.9% in the year to August, from 8.7% in February. And Goldman Sachs Group Inc. (GS) forecasts that it will fall as low as 1.5% in 2009.
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