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Fed gets message, lowers key rate

The U.S. central bank reverses course and sends an unambiguous signal about the growing credit crunch.

August 18, 2007|Peter G. Gosselin | Times Staff Writer

WASHINGTON — In an about-face Friday from only 10 days earlier, the Federal Reserve expressed concern that a sudden freeze-up in the financial markets could hurt the economy, trimmed one of its key interest rates and hinted that more help could be on the way.

The central bank's words and action had a bracing effect on the stock market, which had been preparing for another day of wild swings. After four days of declines, some of them very sharp, the Dow Jones industrial average jumped 233.30 points, or 1.8%, to close at 13,079.08. European stocks also climbed as did the prices of oil, copper and gold, all of which had been sinking before the Fed move.

The central bank used uncharacteristically unambiguous language, saying a credit crunch stemming from the sub-prime mortgage meltdown "appreciably" increased the risk of a further slowdown in the economy.

"In Fed-speak, things are either 'slightly' or 'somewhat,' " said Jan Hatzius, chief U.S. economist with investment bank Goldman Sachs Group Inc. "Saying that the risks have increased 'appreciably' is a pretty strong statement for them."

As recently as Aug. 7, as debt woes were rapidly spreading, the Fed said its chief worry was still inflation, not a slowdown of growth.

And as the agency continued taking relatively small steps this week to address growing difficulties in borrowing, some analysts believed that the Fed intended to let the financial markets fix their problems largely on their own as a way of teaching investors that they must live with the consequences of their own bad decisions.

But Friday, the Fed said its interest-rate committee had decided it was time to act.

The central bank cut its so-called discount rate -- the rate it charges banks for direct loans. More importantly, it signaled that it might be ready next month to trim the federal funds rate, which has broad influence on consumer and corporate borrowing costs.

Later in the day, major Wall Street firms such as Goldman Sachs and Lehman Brothers were predicting that a quarter-point cut in the fed funds rate -- the rate at which banks lend to one another -- would come at a meeting set for Sept. 18 and that the rate, which has been at 5.25% for the last year, would be as low as 4.5% by the end of the year.

The last time the Fed cut the fed funds rate was in June 2003, when it fell to 1%. A year later, the central bank began two years of increases in an effort to keep inflation under control.

Friday's discount-rate cut was the first reduction in borrowing costs between scheduled meetings of the central bank's policymaking body since 2001 and the first of any sort since Ben S. Bernanke became Fed chairman in early 2006.

The problem that the Fed has signaled it is prepared to tackle started late last year, when a wave of defaults began to appear on sub-prime mortgages -- loans to people with poor credit -- that were made during the tail end of the housing boom. Soon investors no longer wanted to buy such mortgages or securities backed by them. Sub-prime home-loan firms started going out of business.

As more losses on sub-prime mortgage securities were reported, the crisis spread to the market for high-risk corporate debt, stopping a corporate takeover boom in its tracks.

In recent weeks the troubles began to make it hard for even some highly rated companies, as well as home buyers with good credit, to borrow. The market for commercial paper, a type of short-term debt and the financial lifeblood of many U.S. companies, contracted sharply this week. The crisis threatened the stability of Calabasas-based Countrywide Financial Corp., the nation's largest mortgage lender.

The stock market, which set record highs in mid-July, proceeded to slide in a period marked by steep gains and generally steeper declines.

Analysts warned of trouble, but before Friday the Fed limited its actions to injecting additional credit into the banking system and issuing bland remarks saying, for example, that it was acting to help "facilitate the orderly functioning" of the financial system.

Though the infusions were as big as $36 billion in one day, they weren't meant to lower interest rates, and many investors had called for stronger action.

"The markets are in a very difficult situation," said former Fed governor Lyle Gramley. "I won't say it's been chaos, but it's been very disorderly."

Friday the Fed changed its tune.

"Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward," the central bank said, adding that it was "prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets."

The latest statement increased the likelihood of a fed funds rate cut in September in the minds of many analysts.

It also provoked debate over precisely how far the central bank had gone. Some analysts said the Fed's actions Friday were relatively minor.

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