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Fed cuts interest rates

by John M. Berry

THE WASHINGTON POST

WASHINGTON -- The Federal Reserve cut its target for overnight interest rates by a half-percentage point Tuesday to give the lagging U.S. economy a boost and perhaps help put a floor under falling stock prices.

The central bank's top policymaking group, the Federal Open Market Committee, also signaled that if the economic outlook deteriorates in coming weeks it could cut rates again before its next scheduled meeting May 15.

However, the announcement disappointed many stock investors who had been hoping for a larger rate cut of at least three-quarters of a point. The Dow Jones industrial average lost 238.35 points to close at 9,720.76, its lowest level in two years. The tech-heavy Nasdaq composite index dropped 93.74 points to 1,857.44, its lowest close since November 1998.

The FOMC cautioned in a statement that weak conditions in the manufacturing sector of the economy, where production has fallen and thousands of workers have been laid off, "could continue for some time." Increasing economic problems abroad, particularly in Japan also pose "substantial risks" that could keep the U.S. economy soft for some time to come, the committee said.

Because of these developments, the committee said, the risks the economy faces continue to be "weighted mainly toward conditions that may generate economic weakness in the foreseeable future." In other words, a solid recovery is not yet assured and more rate cuts may be needed.

Acknowledging that the economy, corporate profits and stock investors are all suffering, the FOMC said, "In these circumstances, when the economic situation could be evolving rapidly, the Federal Reserve will need to monitor developments closely." The FOMC used similar language in a statement following its December meeting; Fed officials said later the language was intended to indicate that rates could be cut, if necessary, before their next meeting.

Many investors and analysts did not get the message and were surprised Jan. 3 when the FOMC reduced its target for the federal funds rate, the interest rate financial institutions charge each other on overnight loans, to 6 percent from 6.5 percent. Another half-point cut followed at the next regular committee meeting at the end of January.

The Fed Tuesday lowered the target to 5 percent from 5.5 percent. Many American households and small businesses will benefit shortly from the rate cut because major banks will reduce their prime lending rate to 8 percent from 8.5 percent. Many small business and consumer loans, such as home equity lines of credit and unpaid credit card balances, carry rates that are tied directly to the prime.

The impact on home mortgage rates is less clear. Rates on adjustable-rate mortgages likely will fall somewhat, but rates on 30-year fixed-rate loans have already come down significantly this year, partly because of market expectations of Fed rate cuts.

"With today's half-percentage point cut the Fed has lowered its federal funds rate target by 1.5 percentage points in the first quarter, which is a very aggressive monetary easing," said Mickey Levy, chief economist at NationsBank in New York. "Altogether, that amounts to a faster response than the Fed has had during than in any recent economic slowdown."

"The Fed was wise not to lower rates as much as financial markets had wanted because its credibility hinges on its pursuit of its long-run objectives of stable, low inflation and sustainable economic growth. It can't keep that credibility if it tries to meet the market's short-run desires."

In contrast, economist Peter Hooper of Deutsche Banc Alex. Brown Economics, said the Fed's action will help the economy but not right away and a larger cut would have been better.

"We think this is a mistake," Hooper said. "The risks and momentum of the economy are clearly downward at this point, despite recent news of moderate growth in some sectors."

The Fed Board also acted separately Tuesday to cut a half-percentage point off the discount rate financial institutions pay when they borrow funds directly from one of the Fed's 12 regional reserve banks.

The economy grew at a sluggish 1.1 percent annual rate in the final three months of last year and many forecasters predict about the same for the quarter that ends next week. Several Fed officials have said that after a very slow first half for 2001, they expect growth to pick up, reaching a 3 percent or so pace before the end of the year.

However, some private economists think the period of very slow growth -- including perhaps at least one quarter in which the economy contracts -- could extend well beyond the first half of this year.

A number of factors probably kept the Fed from cutting rates by more than a half-point. Recent economic reports have pointed to slow growth but not to an imminent recession, and Fed officials do not want investors to expect the central bank to step in to prop up stock prices. Other parts of the financial markets, such as the bond market, show much less distress than do stocks. And even the stock market slide, while deep and prolonged, has been orderly -- in contrast to October 1987 when crashing stock prices threaten to disrupt the entire U.S. financial system, and the Fed cut rates forcefully to keep the markets functioning.

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