Fed eyes rate cuts to calm market

The central bank eased jitters Friday, but analysts wonder if it's enough to avoid recession.

By Ron Scherer | Staff writer of The Christian Science Monitor

from the August 20, 2007 edition

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New York - Concerned that turmoil in the credit markets might spark a broader economic slide, the Federal Reserve is now signaling that it may cut interest rates – perhaps next month.

An interest-rate cut would be the latest weapon employed by the central bank to try to bolster the short-term debt markets, which have been frozen by investor fears about the quality of loans.

Some analysts worry that the economy, though strong now, could skid to a halt by year's end if investor confidence isn't restored. The Fed itself now acknowledges that credit-market problems could spill over to the broader economy. The risks to growth "have increased appreciably," it said in a statement Friday.

"The odds of a recession are now 50-50," says Lyle Gramley, a former Fed governor. "Conditions have become extremely unstable and outright chaotic in the mortgage market."

For more than a week, the Fed, as well as other central banks around the world, provided overnight emergency funds to try to ease the pressure on the world's commercial banks. Despite those efforts, the credit markets are still jittery. On Friday, as part of its efforts to change the psychology in the markets, the Fed also cut the discount rate by half a percentage point. The discount rate, one of the Fed's more obscure monetary levers, is the rate at which commercial banks can borrow money from the Fed itself.

"The Fed's lowering of the discount rate helped to solve some of the concerns," says Michael Carey, an economist at Calyon, a French investment bank, in New York.

On Friday, after the Fed's announcement, the stock market recouped some of its recent losses with the Dow Jones Industrial Average gaining 233.30 points to close at 13079.08, up 1.8 percent.

Economists also believe the Fed will act to lower the short-term interest rates known as the Fed Funds rate when it meets on Sept. 18. The Fed Funds rate, which has more direct bearing on short-term consumer rates, is the interest rate which banks lend their balances at the Fed to other banks. The current rate is 5.25 percent.

"I think there is a 90 percent chance they will ease on Sept. 18," says Mr. Gramley, now a consulting economist at Stanford Policy Research in Washington.

Some Wall Street economists expect the Fed to drop rates in October and December as well.

On Aug. 7, the Federal Reserve held interest rates steady and said the downside risk to growth had only "increased somewhat." Instead, it said it was more concerned about the risk of inflation.

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