Fed cuts interest rates a quarter-point

John W. Schoen Senior producer • Profile • E-mail

The Federal Reserve Wednesday cut interest rates for the second time in six weeks signifying that the central bankers — for the moment — are more concerned with the recent turmoil in the financial markets and possible weakness in the economy than with fighting inflation.

Despite a report showing stronger-than-expected economic growth in the third quarter, the Fed cut the benchmark overnight rate a quarter-point to 4.5 percent, and made a similar quarter-point cut in the less-important discount rate. The move had been widely anticipated by financial markets, as futures traders had placed bets on a quarter-point cut.

“If it weren’t for those market expectations, I don’t think the Fed would be cutting,” said Alan Blinder, a Princeton Univeristy economist and former Fed vice chairman.

Wall Street applauded the move, with the Dow Jones industrial average rising more than 137 points, or about 1 percent.

In its statement accompanying the vote, the Fed said that it now thinks the risks of recession and higher inflation are in “balance” — a signal that the Federal Open Market Committee is less likely to make another cut down the road. To emphasize the point, the FOMC highlighted concerns about higher oil and other commodity prices and said the central bank would “continue to monitor inflation developments carefully.”

The careful choice of words was seen by some as a sign that the central bank is trying to avoid the impression that its policy decision placed the interests of the finacial markets ahead of the its broader mandate to promote economic growth and stable prices.

"They get trapped into having to do what the market wants,” said Robert McTeer, a fellow at the National Center for Policy Analysis and a former head of the Dallas Fed. “I believe this was a little bit of a declaration of independence.”

CNBC video   Rate cut analysis Oct. 31: A panel of experts on CNBC discusses the Fed’s decision to cut interest rates again at the conclusion of its two-day meeting Wednesday. CNBC

The decision to cut both the federal funds rate, which banks pay each other for short-term loans, and the discount rate on direct borrowing from the central bank will help cut borrowing costs for businesses and consumers on a wide range of loans including home equity credit lines and some credit cards. Commercial banks immediately lowered their prime rate a quarter-point to 7.5 percent. The cut could also indirectly ease rates on longer-term rates like home mortgages.

The case for making the cut was far from clear. After a surprise half-point cut last month to quell turmoil in the credit markets, the Fed faced a difficult choice Wednesday heading into the second day of rate-setting deliberations.

Investors have been betting on a cut largely because of ongoing bad news from the housing market, as both the pace of building and home prices continue to decline. Though the credit markets have settled somewhat — since all but shutting down briefly in August — recent reports of big mortgage-related losses on Wall Street have left lenders and investors nervous about the possibility of future losses. Foreclosure rates are expected to continue to rise, especially among borrowers who hold mortgages with low “teaser” rates that are set to jump next year.

So far, the recession in the housing industry doesn’t seem to have spilled over to the broader economy. On Wednesday the Commerce Department reported that its first estimate of economic growth for the third quarter showed that U.S. gross domestic product advanced by a healthy 3.9 percent rate, faster than most economists had expected.

But central bankers focus on what lies ahead. And economists say the outlook for next year is unclear.

“Expectations are that the holiday season will be relatively flat,” said John Lonski, chief economist at Moody’s Investor Service. “And as we look ahead, we don’t have a strong reason to believe that hiring activity will be strong enough to offset the weakness from possibly lower home prices.”

Lyle Gramley, a former Fed board member and now an economist with Stanford Financial Group, put the chances of a recession at around 40 percent, saying the Fed’s primary concern right now is what is happening in housing and how much of a spillover that will have on the overall economy.

“It is possible that the housing industry will take us over the edge into a recession,” he said, noting that every housing downturn of the past 60 years with the exception of two have triggered recessions.

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