Fed Cuts Rates 3/4% in Futile Attempt to Stave off Recession

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Jan. 22 (Bloomberg) — The Federal Reserve cut the benchmark interest rate by three quarters of a percentage point, its first emergency reduction since 2001, after stock markets tumbled from Hong Kong to London amid increasing signs of a U.S. recession.

The central bank cut the target overnight lending rate to 3.5 percent from 4.25 percent, the Federal Open Market Committee said in a statement in Washington. Policy makers weren’t scheduled to gather until next week. It’s the biggest single reduction since the Fed began using the rate as the principal tool of monetary policy around 1990.

“Broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households,” the Fed said in a statement in Washington. The FOMC took the action “in view of a weakening of the economic outlook and increasing downside risks to growth.”

Policy makers set aside concerns about inflation to lower borrowing costs for the fourth time since September after retail sales fell, the unemployment rate climbed and global stocks slumped. Chairman Ben S. Bernanke shifted the Fed’s stance to a more aggressive approach in remarks this month citing a need for “decisive and timely” action.

The dollar slid and Treasury securities rallied after the announcement. Stocks retreated as some investors questioned whether the Fed would be able to avert a recession, and then recouped more than half the losses. The Standard & Poor’s 500 Index fell 1.1 percent to 1,310.50 in New York, the fifth straight drop, extending its decline to 11 percent this year.

Bear Market

Yesterday, almost half of the world’s biggest stock indexes fell into a bear market as mounting concern about a U.S. recession dragged down banking and retail shares across Asia, Europe and Latin America.

“The bottom line was that financial conditions were tightening sharply” and affecting the economic outlook, said former Fed economist Brian Sack, who is now with Macroeconomic Advisers LLC in Washington. “The view so far has been that they’re somewhat behind the curve and needed to adopt a somewhat more aggressive approach.”

Economists differed over what the Fed will do when it meets next week. Deutsche Bank forecast a half-point reduction in the benchmark rate, while Morgan Stanley and Lehman Brothers Holdings Inc. predicted a quarter-point cut. Goldman Sachs Group Inc. said the Fed will leave the rate unchanged, then changed its call to a half point. Traders see a half-point reduction as more likely, based on futures prices.

`Smell Blood’

“The markets smell blood right now,” said Stephen Stanley, chief U.S. economist at RBS Greenwich Capital Markets in Greenwich, Connecticut. “I don’t think the Fed can afford to disappoint.”

The Bank of Canada, in a scheduled meeting, lowered its main interest rate by a quarter point today to 4 percent and signaled it will act again to shield Canada from the U.S. slowdown. The Bank of England said it has no plans to change the date of its next rate decision. The bank’s policy makers are due to begin a two-day meeting in London on Feb. 7.

Treasury Secretary Henry Paulson called the Fed’s move “very constructive” and a “confidence builder.” He also said it was a sign to the rest of the world that the U.S. central bank is “nimble.”

Negotiating Stimulus

Paulson, charged by President George W. Bush last week with negotiating a fiscal stimulus plan with lawmakers, said a package “must be enacted quickly.” White House spokeswoman Dana Perino told reporters that the administration hasn’t ruled out a proposal exceeding $150 billion.

The Fed Board of Governors, in a related move, lowered the so-called discount rate on direct loans to commercial banks by a 0.75 percentage point to 4 percent. The Chicago and Minneapolis district banks had requested the reduction, the Fed said. In August, the Fed made an emergency half-point cut in the discount rate without lowering the federal funds target.

“Appreciable downside risks to growth remain,” the Fed statement said. “The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.”

Traders had anticipated 75 basis points of rate cuts this month, according to futures prices on the Chicago Board of Trade.

The FOMC vote was 8-1, with St. Louis Fed President William Poole preferring to wait until the regularly scheduled meeting. Fed Governor Frederic Mishkin was absent and not voting.

Video Conference

Fed officials met by video conference at about 6 p.m. yesterday, spokeswoman Michelle Smith said. Mishkin was traveling and unable to participate, she said. The voting members were the same as in 2007 because the presidents don’t rotate in until the first regular meeting, Smith said.

Poole declined to comment, said his spokesman, Joe Elstner.

Today’s so-called inter-meeting rate cut is the first for the federal funds rate since Sept. 17, 2001, when the Fed lowered borrowing costs in the aftermath of the terrorist attacks six days before. That was the third emergency reduction in a year which saw the last U.S. recession.

Bernanke warned in a Jan. 10 speech and again in testimony to Congress Jan. 17 that the 2008 economic outlook had worsened and “the downside risks to growth have become more pronounced.” Still, he said the Fed wasn’t forecasting a recession this year.

Faltering Economy

Retail sales fell last month, unemployment rose, and housing markets are mired in the worst slump in 16 years. Homebuilders broke ground on the fewest homes since 1991 last month, Commerce Department figures showed Jan. 17. Building permits, a sign of future construction, declined by the most in 12 years, suggesting the housing slump will deepen.

Bernanke told legislators at the House Budget Committee that banks were trying to protect asset quality and funding, and tightening credit conditions for the rest of the economy as a result. “Banks have also evidently become more restrictive in their lending to firms and households,” he said. The Fed statement reprised the remarks today.

Fed policy makers have warned that housing will continue to be a damper on growth. Richmond Fed President Jeffrey Lacker said Jan. 18 that didn’t expect homebuilding to “bottom out” in 2008. Bernanke said the day before that housing markets “may continue to be a drag on growth for a good part of this year.”

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net

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