Fed slices interest rates to reduce fallout from housing bust

By Jack Egan Sep 19, 2007, 1:27 GMT

In a double-barreled blast, the Federal Reserve Board today cut its benchmark federal funds rate by a larger-than-expected half a percentage point, and did the same for the bank discount rate.

The immediate response by a thrilled stock market, which had been banking on a more modest quarter-point cut, was to send the Dow soaring by 300 points.

The slide in the federal funds rate to 4.75 percent from 5.25 percent comes in the wake of a spreading United States housing bust that was seen as posing a threat to the broader economy and creating distress in financial markets around the globe. 

The reduction in the key rate is expected to spill over into other business and consumer lending rates, causing them to decline as well.  The hope is that this decline will give many financially pressed homeowners a breather.

To ease conditions in financial markets, the Fed also cut the discount rate,  at which banks can borrow directly from the central bank,  to 5.25 percent from 5.75 percent. This was the second half-percentage-point cut in a month for the discount rate, a further sign of urgency.

The Fed, in its rate-cutting statement, said "the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally."  It's half-point cut was "intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets."

This is the first full-fledged financial crisis on the watch of Fed chairman Benjamin Bernanke who two years ago succeeded Alan Greenspan.   Bernanke managed to get a unanimous vote on the rate cut from the members of the Fed's Open Market Committee, even though some on the rate-setting body were reportedly concerned about a potentially worsening inflationary environment, which could be exacerbated by the cut in rates.   Oil hit a new record of over $81 a barrel simultaneously with the announcement of the Fed's actions.

However earlier today the government reported wholesale prices declined 1.4 percent in August, due to reduced energy and food costs, but the core rate rose by 0.2 percent.

Following the aggressive easing by the Fed, the question on investors' minds is whether this is the beginning of a new declining rate cycle, or merely an emergency intervention to calm financial markets. One factor inhibiting further cuts anytime soon could be what happens to the dollar. If the greenback's recent steady decline against other currencies accelerates, the Fed may have to backtrack and could start raising rates again.