Fed cuts overnight interest rate to 1.25 percent

By John M. Berry
Washington Post

Increasingly worried that U.S. economic growth is close to stalling, Federal Reserve officials yesterday cut a key short-term interest rate to its lowest level in more than four decades to help lift the economy over what they called "this current soft spot."

Wall Street reflected mixed emotions to the Federal Reserve's surprising half-point cut in interest rates, with investors cheering the decision but also worrying that such a strong move signaled a stumbling economy. Associated Press

Those extraordinarily low rates are a sign of how seriously Fed Chairman Alan Greenspan and other Fed officials regard the failure of the U.S. economy to sustain a stronger recovery this year.

They do not expect the economy to slip back into a recession, but they are using the only tool at their disposal, interest rate cuts, in an effort to make sure that does not happen.

Fed officials fear a renewed slump would cause joblessness to rise, business profits to fall and perhaps a a further slide in stock prices.

In addition, they want to make sure that economic weakness does not cause a decline in the overall level of prices of goods and services in the United States, a process known as deflation.

If deflation were to take hold, it would make it harder for consumers and businesses to repay their debts, which could further depress economy activity. Importantly, deflation also could sap the ability of monetary policy to revive the economy, as it has in Japan.

"The data justify strong medicine," said economist Ed McKelvey of Goldman Sachs in New York. "The litany of weakness is impressive."

Consumer spending, adjusted for inflation, fell in September and probably stayed there in October, McKelvey said. Meanwhile, businesses' purchases of new equipment weakened in September and manufacturing activity appears to have declined in October for the third consecutive month, he noted, adding, "And the labor market is dead in the water."

"We are not alone in thinking that this amounts to a virtual stall ... in the fourth quarter," McKelvey said, noting that Goldman Sach's forecasts that the economy will grow at a very weak 0.5 percent annual rate in the last three months of the year, and at only a slightly better 1.5 percent rate in the first three months of next year.

In the past year, the nation's inflation-adjusted gross domestic product increased 3 percent, but that rate of growth was not strong enough to put much of a dent in the unemployment created by last year's recession. The jobless rate edged up to 5.7 percent last month while payroll employment has fallen in the last two months.

The Fed's move will lower the cost banks incur to get money to lend, and likely will pass those savings on to the larger, most credit-worthy firms. Fed officials believe that — as economists put it — at the margin, some firms will be more willing and able to borrow more to finance new capital spending or additions to their inventories, both of which could boost economic growth.

Stock market investors weren't quite sure how to react to the Fed move. Many of them had already factored a rate cut into their thinking but were looking for only a quarter-point reduction.

In fact, some worried that a half-point would be seen by some as a sign the economy was even weaker than many believed. When the larger-than-expected cut was announced, the market initially jumped ahead and then steeply retreated, before beginning a gradual ascent to close up modestly for the day.

"Eventually the rate cut came to be seen as good news," said Brian Piskorowski, a market analyst at Prudential Securities Inc.