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Fed moves to quell downturn

Reuters, Staff

Wednesday, January 30, 2008

WASHINGTON — The Federal Reserve cut U.S. interest rates by a hefty half-percentage point Wednesday as part of an aggressive effort to halt a sharp slowdown in an economy hit by a housing slump and a credit crunch.

The Fed's action takes the bellwether federal funds rate target to 3 per cent, the lowest since June, 2005, and comes just eight days after it slashed rates by a bold three-quarters of a point. Wednesday's follow-up reduction was in line with the expectations of many financial market participants.

The cumulative 1.25 percentage point reduction in the benchmark overnight rate in less than two weeks ranks among the most abrupt rate-cutting sprees in the modern history of the U.S. central bank.).

The vote to lower interest rates was not unanimous. Dallas Federal Reserve Bank President Richard Fisher dissented, preferring to hold rates steady.

U.S. stock markets turned positive after the Fed's decision was announced, while prices for short-term government debt briefly rose and the dollar fell. Stocks turned negative in late-session trading after CNBC reporter Charles Gasparino said he believed that ratings agencies may downgrade bond insurers Ambac Financial Group Inc. and MBIA Inc.

“Today's policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain,” the Fed said in a statement, leaving the door open to future rate cuts.

However, when the Fed lowered rates on Jan. 22 it had cited “appreciable downside risks to growth,” suggesting policy-makers now think rates are better positioned.

“The Fed is demonstrating that they are getting ahead of the curve,” said Jeff Kleintop, chief market strategist at LPL Financial Services in Boston. “Maybe they feel that now, with this latest policy action, they have taken the worst-case scenario of a deep recession off the table.”

The Fed's action comes on the heels of a government report showing that the economy grew at a weak 0.6 per cent annual pace in the last three months of 2007 as consumers curbed spending and home building plunged. Growth of 2.2 per cent for all of 2007 marked the economy's weakest expansion in five years.

At the same time, a report showing private-sector employers added three times as many jobs as expected in January and a report earlier this week showing a big rise in orders for U.S.-made durable goods pointed to some economic resilience.

Policy-makers are concerned a period of protracted financial market turmoil and tighter credit could lead businesses and consumers to retrench.

“Financial markets remain under considerable stress, and credit has tightened further for some businesses and households,” the Fed said. “Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labour markets.”

However, the central bank also repeated that it would be monitoring inflation developments carefully, even though it expects inflation to moderate in coming quarters.

“The Fed is still poised to pare rates further, with a ‘zero real' target of 2 per cent in our view,” said Michael Gregory, BMO Capital Markets senior economist. “The Fed might attempt to get there more cautiously going forward ... but the pace will ultimately be dictated by the economic data and financial conditions.”

In August, rising defaults on U.S. subprime mortgages led to a seizing up of credit markets. While conditions have improved, aftershocks from the subprime mortgage crisis have continued and financial markets remain volatile.

The latest wrinkle in the unfolding saga of exposure to bad debts was the possibility that bond insurers could suffer ratings downgrades, leading to more losses at banks.

U.S. stock markets stumbled earlier this month, although equities prices have stabilized since the Fed's surprise rate cut on Jan. 22.

The drop in the housing market continues to be gut-wrenching. Sales of new single-family homes fell 4.7 per cent in December to the slowest annualized rate since 1995, the government said Monday. For last year as a whole, sales were off a record 26 per cent, even though builders slashed prices.

Voices weigh in on the Fed decision

Stewart Hall, market strategist at HSBC Securities (Canada) Inc.:
“I get the sense the Fed is moving back from a near-mechanical stimulus response process where markets price in an aggressive rate move, almost creating a compelling need for the Fed to meet those expectations. Responding to market conditions with monetary policy is fraught with risk ... and in a sense, they are trying to put themselves back into the driver's seat and regain control of the process.”

Michael Gregory, senior economist at BMO Capital Markets:
“In referring to the cumulative moves to date and removing the ‘appreciable' adjective to the downside risks, the Fed's appetite for further aggressive cuts appears to be waning, a sentiment embodied by Dallas Fed Pres Fisher's dissenting vote to keep rates steady today. The Fed is still poised to pare rates further, with a ‘zero real' target of 2 per cent, in our view. The Fed might attempt to get there more cautiously going forward ... but the pace will ultimately be dictated by the economic data and financial conditions.”

Peter Morici, a business professor at the University of Maryland:
“The Federal Reserve cut the federal funds rate a half point to 3 per cent, as expected. It really had little choice. In recent months, Ben Bernanke has flip-flopped so much regarding his outlook for the economy and need for further cuts, he really could not afford to disappoint market expectations again. Sadly, recent Fed moves and the stimulus moving through Congress will not likely be enough to avoid a serious slowdown in growth or even a recession, as defined by two quarters of negative growth.”

David Cockfield, fund manager at Leon Frazer Associates Inc.:
“The Fed cut seems to be a positive for stocks in New York and in Toronto. Of course, Toronto tends to overreact to what is happening south of the border instead of focusing on what is happening in its own back yard. I think if the Fed had come in at 25, we would be deep underwater right now. But there are still a lot of people out there who are uncertain and I think we need a day to digest this. Some people felt 50 points would indicate there are still more problems hidden. I think we are going to see more negative announcements out of the financial sector.”

Stefane Marion, assistant chief economist for National Bank Financial:
“Though the Federal Reserve acknowledges that actions taken so far should help promote growth — it has after all cut rates by a massive 225 basis points since September 18 — it nonetheless still views downside risks to growth. In our opinion, most members of the FOMC are well aware that in order to ensure that the highly-leveraged U.S. economy does not go into a tailspin, real interest rates must be brought to zero. At this time, we still see the fed funds bottoming at 2.5 per cent later this spring, especially if Congress allows the fiscal stimulus to proceed quickly.”

© The Globe and Mail