WASHINGTON (AP) – The Federal Reserve cut a key interest rate for the first time in four years, starting with an aggressive half-point move to prevent a steep housing slump and turbulent financial markets from triggering a recession. The action triggered a huge rally on Wall Street.
The Fed announced Tuesday that it was reducing its target for the federal funds rate, the interest that banks charge each other, from 5.25 percent to 4.75 percent.
The half-point reduction was double the quarter-point move that many had expected and sparked euphoria among investors, who had been worried that the central bank would be too slow in responding to recent market turmoil.
The Dow Jones industrial average, which was up by 84 points right before the announcement, soared by more 200 points in the first 10 minutes after the mid-afternoon announcement.
The Fed's action is designed to boost economic growth by lowering borrowing costs for millions of consumers and businesses. Commercial banks were expected to quickly match the Fed's action by cutting their prime lending rate. The prime rate has been at 8.25 percent for the past 15 months.
The Fed's action came in the midst of the worst slump in housing in 16 years. That downturn has triggered record defaults in subprime mortgages and roiled financial markets around the globe as investors have become worried about where the spreading credit problems will next appear.
The financial market turmoil represents the first major test for Fed Chairman Ben Bernanke, who took over from the venerable Alan Greenspan in February 2006.
In addition to cutting the federal funds rate by a half point, the central bank also reduced its discount rate, the interest it charges in making direct loans to banks, by a half-point as well.
The Fed had also cut the discount rate on Aug. 17 as it scrambled to respond to the growing credit crisis.
In explaining its action Tuesday, the Fed said that “the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally.”
Many analysts had predicted that Bernanke, who has been cautious since taking over as Fed chairman, would opt for a quarter-point move, the change in rates usually preferred by Greenspan.
But with this action, Bernanke appeared to be trying to surprise financial markets with a positive change after disappointing investors following the Aug. 7 meeting when he and fellow board members refused to change rates and still said inflation was the biggest threat facing the economy.
“Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time,” the Fed said in a brief statement explaining its actions.
Analysts said rate cuts were certainly needed, given spreading weakness in housing, financial market turbulence and a bad August employment report which showed the labor market lost jobs for the first time in four years.
“We have a very soft economy and if the Fed doesn't lower rates then the economy could fall into a recession,” said Mark Zandi, chief economist at Economy.com.
Zandi said he had trimmed his forecast to show economic growth of around 2.5 percent in the current quarter, down sharply from 4 percent growth rate in the April-June quarter. He said the fourth quarter is likely to be even weaker — at around 1.5 percent.
Analysts believe the Fed has room to cut rates because inflation pressures have been easing. In good news on that front, the Labor Department reported Tuesday that wholesale prices fell by 1.4 percent in August. It was the biggest drop in 10 months and much larger than the 0.3 percent fall that had been expected.
Economists said they believed that Bernanke, who wrote extensively as an economics professor on the Great Depression that followed the 1929 stock market crash, understands what needs to be done to avert downturns.
“We have had a long history of financial panics and if we have learned anything, it is that you shove money at them,” said David Wyss, chief economist at Standard & Poor's in New York.
While some have complained that Bernanke has been more tentative than Greenspan would have been, no less an authority than Greenspan disagrees.
Doing a round of interviews to promote his new book, Greenspan, who was Fed chairman for 18 1/2 years, said Bernanke was “doing an excellent job” and he doubted that he would have done anything differently.
Greenspan told The Associated Press on Monday that the odds of a recession have grown since earlier this year, even though “the economy is not doing badly at this stage.”
He put the odds of a recession at greater than one in three. “But best I can judge it is less than 50 percent,” he said.
Greenspan's one-in-three prediction earlier this year rocked Wall Street.