Not the Deepest Rate Cut


The Fed's cut of three-quarters of a percentage point is less than investors were expecting, but markets rallied nonetheless

After weeks of surprisingly aggressive moves to arrest the credit crunch, the Federal Reserve on Mar. 18 surprised the markets in the opposite direction—cutting interest rates a bit less than anticipated. It cut the federal funds rate by three-quarters of a percentage point, to 2.25%, rather than the 1% cut that most traders had been expecting.

What's more, two of the voters on the Federal Open Market Committee dissented, saying they thought the cut was too aggressive. That indicates Federal Reserve Chairman Ben Bernanke might not be able to gather enough votes to push rates much lower if he thinks doing so is necessary to protect the economy.

But even though the Fed's action fell short of expectations, it failed to wipe the smiles off the faces of market players. Investors have suddenly turned mildly optimistic, after weeks of panic. Stock prices dipped only briefly after the 2:15 p.m. EDT announcement before snapping back to around their daily highs. The Dow Jones industrial average surged 420 points, or 3.5%, to finish at 12,392. It was the largest one-session gain in more than five years.

Pacifying Inflation Hawks

Justifying the decision to cut rates, the Fed issued a statement saying "the outlook for economic activity has weakened further," noting among other things "the tightening of credit conditions and the deepening of the housing contraction." The FOMC acknowledged that "some indicators of inflation expectations have risen." But it said the committee "expects inflation to moderate in coming quarters" as energy prices level out and the economy softens. Lowering rates threaten to drive up inflation.

The two biggest inflation hawks on the rate-setting committee, Federal Reserve Bank Presidents Richard Fisher of Dallas and Charles Plosser of Philadelphia, preferred less aggressive rate cuts at the meeting. Nodding in their direction, the committee said, "it will be necessary to continue to monitor inflation developments carefully."

Analyst Reactions

Giving the financial markets a smaller rate cut than expected ran the risk of setting off a huge sell-off on Wall Street. The Fed was "risking the wrath of the markets," wrote economist Paul Ashworth of Capital Economics. Ashworth said he expects the Fed to keep cutting the funds rate all the way to 1% by summer because, in his view, the economy is going to get much worse. "Once recessions start, conditions tend to get worse, very quickly," Ashworth wrote in an instant analysis of the Fed's action.

Still three-quarters of a percentage point is no small cut, especially since it comes on the heels of other big cuts. The federal funds rate—the rate that big banks pay to borrow funds from each other overnight to meet reserve requirements—is now fully 3 percentage points below the 5.25% rate of last summer. In a statement, Swiss Re (SWCEF) Senior Economist Arun Raha called the Fed move "yet another forceful move in its attempts to alleviate the liquidity crunch and to shore up a rapidly weakening economy."

Coy is BusinessWeek's Economics editor.

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