Fed makes half-point cuts to fed funds and discount rates

US stock markets rallied on the first cut in the federal funds rate in more than four years.

By GREG ROBB, MARKETWATCH
September 19, 2007 07:46
3 minute read.

 
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MarketWatch: In-depth global business coverage The Federal Reserve unanimously cut its overnight interest rate by a half percentage point to 4.75% Tuesday, citing turmoil in financial markets as a threat to economic growth. US stock markets rallied on the first cut in the federal funds rate in more than four years. Financial markets and analysts had been expecting a smaller quarter-point cut. The Fed also cut the discount rate by a half percentage point to 5.25%. "Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time," the statement from the Federal Open Market Committee said. The committee said growth had been moderate, but judged that "the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth." "Developments in financial markets since the committee's last regular meeting have increased the uncertainty surrounding the economic outlook," the statement said. The FOMC signaled that further rate cuts could be coming, saying it would monitor the situation and that it stood ready act if necessary. Inflation readings had improved modestly, the FOMC said, but some inflation risks remain. The drop in the fed funds rate is expected to be matched almost immediately by banks dropping their prime lending rate. Bank of America lowered its prime rate within minutes of the announcement. Most banks peg their prime lending rate to the fed funds rate. The interest rate on many adjustable-rate mortgages and credit card debts is pegged to the prime rate. What started as turmoil in the market for sub-prime mortgages, those mortgages at less than the best credit quality, has mushroomed into a global credit crunch. Savvy and wealthy investors, hedge funds and banks found that they held sub-prime loans as part of complex derivative securities. Since mid-August, financial market conditions have worsened. Cost of credit has soared and its availability has been limited. This forced the Fed to quickly switch direction. After saying in early August that inflation was its number one concern, the Fed said on August 17 that downside risks to growth had "increased appreciably." Since then, concern about the economic outlook has grown and economists have been busy cutting their forecasts for the fourth quarter and early next year. Fed Chairman Ben Bernanke said three weeks ago that the central bank is paying "particularly close attention to the timeliest indicators" to assess how the recent credit crisis and market turmoil are affecting the real economy. In a sense, Fed officials are relying on their gut instincts as there is little firm evidence yet that the tight credit has hurt the economy. And after the August employment report showed the first drop in payroll jobs in four years, market expectations of a rate cut were cemented. Before the announcement, economists were leaning slightly toward the expectation that there would be a quarter-point cut, but many favored a more aggressive half-point cut. This is the first cut in the federal funds target rate since June 2003. The funds rate is at its lowest level since May 2006. The federal funds rate is the rate banks charge each other for overnight loans to meet the Fed's reserve requirements. By buying and selling short-term Treasury bills, the Fed manipulates short-term rates in the market, allowing banks to increase or decrease the funds available for loans. Over the last month, the effective funds rate has been lower than the Fed funds rate. Some economists said it was an extra bit of liquidity from the Fed. Ultimately, the fed funds rate influences even longer-term rates, such as mortgages, corporate bonds and Treasury notes. The separate discount rate is the rate it charges banks to borrow money from its discount window. Reducing the rate is seen as a way to add liquidity to financial markets. The rate, which has little impact on consumers, is set by the seven members of the Fed board of governors. MarketWatch: In-depth global business coverage

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