Why the Fed Didn't Cut the Funds Rate


Surprise: Bernanke & Co. are still worried about inflation, not just the Wall Street credit crunch

Scratch that rate cut. Despite a severe credit crunch, Chairman Ben Bernanke and other members of the Federal Reserve's interest-rate-setting committee voted unanimously on Sept. 16 to leave the federal funds rate at 2%, disappointing bankers who had expected a cut of a quarter or even half a percentage point to stimulate the U.S. economy and lower their borrowing costs. The Federal Open Market Committee acknowledged growing troubles in the financial and labor markets but said: "The downside risks to growth and the upside risks to inflation are both of significant concern."

Wall Street took the Fed's brush-off in stride, possibly reading the Fed's refusal to cut rates as a signal that the financial situation is less dire than feared. The Standard & Poor's 500-stock index, after falling about 1.5% immediately after the Fed's 2:15 p.m. EDT announcement, bounced upward about 2.5% and was trading near its daily highs toward the end of the session.

The Fed's continued "significant concern" with inflation was the biggest surprise in its announcement, because headline inflation numbers have turned extremely mild. Earlier in the day, the Labor Dept. announced that the consumer price index actually fell 0.1% in August, led by a steep decline in energy prices. After hitting $145 a barrel in early July, crude oil has plummeted on concerns that a global economic slowdown will decrease demand. On Sept. 16 oil fell $4.91, to $90.80 a barrel, on the New York Mercantile Exchange.

Doing Plenty

In a week of deep uncertainty on Wall Street, the Fed is doing plenty to keep the gears turning in the financial system, even though it didn't cut rates. The Fed injected a bigger-than-usual $70 billion into the U.S. banking system on Sept. 15 to satisfy a cash-hoarding surge among banks. It pumped in a further $50 billion on Sept. 16. The injection of funds limited a spike in the federal funds rate, which is the rate that banks charge each other for overnight loans.

Analysts said that by voting against a rate cut, the Fed seems to be focusing on ensuring that borrowing is freely available rather than making borrowing cheaper. Stuart Hoffman, chief economist of PNC Financial Services Group, said in an interview that cutting rates would have been "the wrong weapon aimed at the wrong target." Paul Ashworth, senior U.S. economist of Capital Economics, said in a statement after the vote: "The Fed is now more than ever determined to tackle the funding problems in financial markets by widening the scope of its liquidity programs rather than lowering interest rates."

In this credit crunch the Fed has vastly expanded its lending programs, accepting more kinds of assets as collateral and even opening lending to investment banks for the first time. Those moves are apart from whatever the lending rate is. Before the vote, Robert McTeer, former president of the Federal Reserve Bank of Dallas, told Bloomberg Radio: "We have a very concentrated problem in housing that's not really a rate problem, and we've got a financial crisis that's really not a rate problem."'

But if the credit crunch causes further weakness, the Fed is likely to be forced to cut the federal funds rate. Hoffman, the PNC economist, said: "They've at least opened the door to a rate cut, even if they're not ready to step across the threshold."

Coy is BusinessWeek's Economics editor.

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