Federal Reserve cuts rates to 1.25% [Half Point Cut, Not The Quarter Point Expected]

WASHINGTON (CBS.MW) - The Federal Reserve cut interest rates Wednesday to try to get the economy humming again.

By cutting the federal funds target rate to 1.25 percent, the Fed hopes to boost consumer and investor confidence and pump more money into an anemic economy.

"Greater uncertainty, in part attributable to heightened geo-political risks, is inhibiting spending, production and employment the Fed said.

It was the first rate cut since December. The Federal Open Market Committee had cut rates 11 times in 2001, bringing the fed funds rate from 6.50 percent to 1.75 percent.

The move was expected on Wall Street. Forecasters were nearly unanimous in their belief that the FOMC would ease monetary policy Wednesday.

Financial markets had fully priced in a 25 basis point cut and were hedging their bets that the cut would be an aggressive 50 basis point cut.

The federal funds rate is the interest rate banks charge each other for overnight loans. The Fed targets this rate by buying or selling Treasurys in the open market. To goose the economy, the Fed adds money to the system. To contract the economy, the Fed takes money out. Read more about monetary policy.

The economy officially entered a recession in March 2001 after months of slipping industrial production and falling stock prices.

The FOMC had held its fire since last December. It is likely that the private-sector National Bureau of Economic Research will eventually determine that the recession ended in December or January -- if the economy doesn't dip back into a recession now.

The NBER said Tuesday that the recession "may have come to an end," but would wait to make its decision.

The FOMC has been warning since August that the main risk to the economy is a relapse, signaling its intention to cut rates again if the economy appears to be worsening. Even before the FOMC changed its official risk assessment, the committee had said the most likely outcome was a tepid recovery, with uncertain growth in consumer spending and capital investment remaining weak for months.

At the Sept. 24 meeting, two of the 12 FOMC members -- Gov. Edward Gramlich and Dallas Fed President Robert McTeer -- voted in favor of an immediate rate cut. It was the first time a Fed governor had dissented in seven years.

The Fed's 11 rate cuts pushed down market interest rates. Automakers offered zero-percent financing on many new cars, which drove sales to record levels. Mortgage rates, too, fell to historic lows, keeping the residential construction and real-estate markets booming.

Throughout the recession, consumers maintained a steady pace of spending, an unusual occurrence in a most unusual business cycle. Consumers' incomes never faltered, due to a timely tax rebate and tax cut and to a relatively low unemployment rate even in the depths of the recession.

But now the evidence shows that consumers have become inured to low rates. Auto sales have fallen back. Retail sales have slowed. Consumer confidence has fallen to nine-year lows, as the bear market and war talk take their toll on consumer psyches.

Some worry that rate cuts wouldn't spur consumer demand because consumers are heavily indebted at the same time they are trying to save more to make up for the pathetic performance of their stock portfolios.

Consumer spending has propped up the economy, which has grown 3 percent in the past year. Growth is uneven, however. In the third quarter, spending on cars accounted for more than half of the 3.1 percent growth rate.

The low interest rates never really benefited businesses. The spread between Treasury yields and corporate bond yields widened, as creditors began asking tough questions about inflated balance sheets.

Companies didn't face a full-fledged credit crunch; neither was there much demand for credit to expand businesses. Companies had to work off their inventories first. Without a pickup in demand, companies had no incentive to invest in new buildings or equipment or to hire workers.

Did the fed wait until after the election to spur the economy to make it harder for Bush ?

Lots of knowledgeable people like Lawrence Kudlow were saying at the last couple of meetings that they should have cut rates. There sure as heck is no sign of inflation, and the recovery has been faltering what with the ISM and Purchasing Managers indexes going into reverse.

Greenspan basically is responsible for Clinton becoming President because he delayed cutting rates for too long in 1990. I don't think it was deliberate, I just think he tends to see a stronger economy and more inflation out there than everyone else is seeing. His image as some kind of economic mastermind is completely undeserved, and as long as he's in there he's a threat to Bush's reelection.

I think things would be clearer if we all could agree to go back to the old time original definitions wherein inflation meant an increase in the money supply and price increases were the result of this and deflation meant the opposite. The current practice of referring to price increases as inflation has not made it easier to communicate. I read an article many years ago in which someone made the statement that inflation was being blamed on price increases by the steel producers and this was equivalent to saying that the rise in river levels had caused the preceding rains. Of course I am one of those old farts who still think that impact is a noun and not a verb so noone is going to pay any attention to what I say.

:"Time to ask the expert"

Not an expert...but I think the Feds are basically impotent right now. They can lower the rates all they want, but if businesses don't borrow (and why should they when many of them are still cutting costs & lowering inventories - so they can't afford to borrow more $ for any new projects) it won't make a difference.

I think chances of defllation are better than inflation, but if the govt keeps up with it's RIDICULOUSLY LARGE spending increases & the war expands, then inflation will happen.

I think consumer spending is overrated - it's business spending that's important. When manufacturing picks up, and businesses increase their R&D spending, then the economy will rebound (beginning with the stock market). That will happen when some of these companies that misspent for a decade continue to go bankrupt, as they should. When the bad ones wash out, the good, efficient ones will be left. They will increase their spending on new technology & increase their productivity & will lower their prices accordingly. Then the lower prices will meet what consumer demand is left.

The stock market always reponds first, and consumers last, in a business cycle. The stock market dropped first, around the time that businesses stopped spending, and now the consumers may finally be catching on. Then the stock market will rise again, with the advent of increased business spending, long before the consumer realizes that the economy is getting better. But how long this all will take is anybody's guess.

If it weren't for the Feds, we wouldn't have this stupid business cycle.

Good point. I think inflation is an increase in the money supply. But maybe because its effects are uneven (helps the ones who get it first, hurts the rest), the definition of inflation gets confused. Then you get your example of inflation being blamed on the price increases of the steel industry.

This slow, steady, inflation that has been going on for years is the worst kind: most people don't really understand that it is hurting them. They only notice when it rises as dramatically as it did in the 70s.

Did the fed wait until after the election to spur the economy to make it harder for Bush ?

YGBSM!!!! The FED telegraphed this move weeks ago and the last 4 weeks have been nothing short of the money interests pumping stocks to give the illusion the economy is in recovery.

The Semiconductor Index is up 68% in the last month on declining earnings and the bleakest business climate in a generation.

I think in general we have to be careful about terms here. The CPI isn't necessarily an indicator of a monetary inflation or a monetary deflation. Simple supply and demand effects can be what is causing an increase in the CPI, but that doesn't necessarily mean it's inflation.

When I think about inflation, I'm specifically thinking about what happens when the supply of money is too great and the value of the standard unit of account (the dollar) is lessened.. so that it takes more dollars to buy something. Generally people use some stable commodity here - which is why gold is so popular. Similarly, deflation is when there are so few dollars in the economy that it takes fewer dollars to buy something. The problem here is that there's no accurate account of how many dollars are out there.. or what the 'right' amount is for the Fed to have in the economy. If people decide that they'd rather pay off credit cards and hoard cash, that's a way to diminish the value of usable dollars in the economy - potentially leading to inflation even though the Fed's money supply hasn't changed.

Some people have recommended (Kudlow and others) that we use a commodity index to understand the pure monetary effects of what is going on with the money supply. My opinion is that this is a better guage than what Greenspan generally advocates.

Certainly, if that index had been utilized over the past 5 years we would not have had some of the dramatic commodity deflations that we experienced.

In my humble opinion, the Feds, or any type of Central Bank, bring about that which they are trying to stop: the booms and busts of the business cycle.

My economic education concentrated in the Austrian trade cycle, and I’m still learning. You sound a lot like Hayek, who believed the central bank made trade cycles worse, but that trade cycles would still be there even without the Feds stepping in, albeit not as bad. But Mises believed that if you got rid of the central bank, the trade cycles would go away. Both believed in the gold standard.

Consider this idea: why is it that so many businesses go bankrupt or experience great difficulties at the same time? Why does this happen? If there weren’t a central bank, wouldn’t it seem reasonable that different businesses would go under at different times due to their own inefficiencies or mismanagement?

It doesn’t make sense to me. Next week Joe should lose his business because he underestimated how much it would cost to make his widget. 8 months later a huge corporation may go under do to increased competition overseas. But why should almost all businesses experience difficulties at the same time? I don’t think this should happen, with the exception of experiencing a war, some type of natural disaster, etc. What do you think?

"You sound a lot like Hayek"

Bingo! Yes, I'm a big fan of his, particularly of his epistemology, even though he's basically irrelevant to the post-socialist period.

"If there weren’t a central bank, wouldn’t it seem reasonable that different businesses would go under at different times due to their own inefficiencies or mismanagement?"

Why do avalanches happen? But actually, it's not question of "if", or philosophy. It's not like we've always had a central bank, after all. Just look at history. It's an empirical question.

Mises makes two errors. The first is the potent directors fallacy. No central bank, no central banker, has ever been able to stand aloof from the markets and make rational policy. They simply rationalize policy.

Put another way, there's nothing external to the markets. The market is not just something that is acted upon by the state. The state and the market are conjoined in a feedback system.

"I don’t think this should happen, with the exception of experiencing a war, some type of natural disaster, etc. What do you think?"

The error is the idea that in the absence of state interference bad business decisions would never be correlated. Business and markets, like many natural systems, exhibit power-law scaling. A bit like earthquakes. There's lots of little uncorrelated failures, but every once in a while we get a magnitude 10.

"The error is the idea that in the absence of state interference bad business decisions would never be correlated. Business and markets, like many natural systems, exhibit power-law scaling. A bit like earthquakes. There's lots of little uncorrelated failures, but every once in a while we get a magnitude 10."

Good point -like the tulip bulb mania? And the .com mania? And the pending real estate bubble bursting? I can see how these could hurt the entire economy when the bubbles burst. But the .com and the real estate bubbles were definitely helped along by the Feds. Take away the easy credit and would they have happened? Or maybe the earthquake would have only been a 5. (Although I think you already made this point, earlier, that the Feds just make the business cycles worse, didn't you?)

What was Mises 2nd mistake...or did I miss that?

"Just look at history. It's an empirical question."

I'll get back to you on that one...I had learned that the business cycles have gotten a lot worse since we've gone off the gold standard and created the Federal Reserve, but that is only what I have been told by my professors, not what I've been able to research myself. I'll have to do that.

"Take away the easy credit and would they have happened?"

I view the fed as a means not a cause.

Yes, blame for many ills can be laid at the feet of the fed. But then my question is: What caused the fed in the first place? The fed is not a godlike uncaused first cause of business cycles.

The answer is only superficially that certain wise (or unwise) men persuaded the body politic to create a central bank. The same arguments for and against were made long before the fed. There's not much really new in today's arguments. Why were those arguments successful in 1913, and other times, and not at other times?

The answer, I believe, is that the impulsive majority of humanity -- the same impulsive majority that from time to time, with power-law frequency, bids up tulips and .coms -- happened to be receptive to the idea.

By this I don't mean to say it was happenstance, at least no more happenstance than, say, the movements of schools of fish.

Reason, IMO, only flatters itself that it sits the throne of the mind of man. Or if it does, its role is usually titular. Truly rare is the person who has mostly mastered their limbic system, or has mastered the ability to ignore it -- and I don't really count myself as one. The best at it include people like successful traders, and some ex-military men (who are disproportionately represented among the first group.)

"What was Mises 2nd mistake...or did I miss that?"

Just his assumption of the correlations that would exist in the absence of state interference. His theory told him such-and-such, but it doesn't seem to me like he ever actually looked.

The bubble will probably not burst, but self-deflate over 2-3 years. For people who were already homeowners before the precipitious rise, it may not really be an issue, unless they took out big loans against their equity. For those who have not, the game is the same and it doesn't much matter what the market does. For example we bought a 100K house in 94, which is now worth about 200+K, and not taken out any loans against the original mortgage. So now we owe about 60K for a 200K house. Even if the market drops by half, back to what it was, we still gain, because it will be easier to to buy a trade-up house for 130K than for 260K, the situation we are facing now.

I read somewhere, either in "The Great Depression of 1990", by Ravi Batra, or "The Great Reckoning" by Lord somebody in the early 90's that even in the Great Depression home prices dropped no more than I think 10%.

Hell, in the crash if the early 90's, prices here dropped about 30%, but no more, reason being that everyone still needs a place to live, so demand doesn't really abate, even in bad times, as living quarters are not a luxury item, per se. After the correction of '87, the lowest real estate prices in NY were to be found in 1994, which is when I bought.

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