Bold 50-Basis-Point Rate Cut in U.S. Boosts Markets

Markets Greet Bold Move

The Federal Reserve's decision to reduce interest rates, after holding them steady for nine consecutive Federal Open Market Committee (FOMC) meetings, was widely anticipated by the markets. There was some debate as to the magnitude of the reduction, but the Fed ultimately delivered what market expectations had gravitated to for several days: a 50-basis-point reduction in the federal funds rate from 5.25% to 4.75%. This was the first cut to the federal funds rate in four years, and the steepest in almost five years. The last heavy rate cuts were seen in January 2001 when the Fed stepped in as recession loomed. In addition, the FOMC decided yesterday to reduce the discount rate by 50 basis points, thereby retaining the unusually narrow spread of 50 basis points between the two rates. Fed chairman Ben Bernanke is normally a champion of steady rates and has been sceptical about a major intervention to allay turbulence, so yesterday's shock therapy was all the more significant. He and fellow FOMC members were clearly convinced that the economic growth prospects were sufficiently compromised to warrant such a move; he has stressed before that the committee would not intervene merely to bail out those who had made bad investment decisions.

Despite the wide expectation of a cut, the markets still reacted very positively and staged a powerful rally. The Fed is being looked to to prevent a sharp drop-off in growth and there has been a clamour in the markets for it to act more vigorously. By the end of the day the Dow Jones Industrial Average had jumped up 335 points, of 2.51%, to 13,739.99. The S&P 500 was up by 2.9%, at 1,519.80. Markets elsewhere in the world took their cue from the United States and made strong advances of their own. Asian markets ended with strong gains; Hong Kong's Hang Seng closed up 4% at a record 25,544.64, for example. European markets have just taken over, with London's FTSE 100 putting on 2% in morning trade. The boost there is particularly welcome after the turbulence triggered by lender Northern Rock's crisis. Markets elsewhere in Europe are up by similar amounts this morning.

The Economic Context

As stated above, the Fed reacted to rapidly worsening U.S. economic outlook. Latest data show a rather sudden slowdown in August, combined with further downward pressures on the housing market and upward pressure on spreads and borrowing rates. The forest fires in the economy had been spreading rapidly in the July–August period, and the Fed has recognised that it is going to take more than just a few buckets of water to bring the situation back under control. The data that may have finally convinced the Fed were the surprisingly poor labour market figures for August. Jobs were shed for the first time in four years (see United States: 10 September 2007: Payroll Employment Declines in U.S. for First Time in Four Years). It is also clearly concerned about the credit conditions: “The tightening of credit conditions has the potential to intensify the housing correction and restrain economic growth more generally…Today’s action is intended to forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets.” On the same day as the announcement was made there was further bad news from the housing sector. RealtyTrac reported that the number of foreclosure filings was 36% higher in August than in the previous month, and a whole 115% higher than in August 2006. The mass expiry of teaser rates on many sub-prime mortgages has caused the problem to escalate rapidly.

Outlook and Implications

This action by the Fed will substantially mitigate the impact of recent upward pressure on LIBOR inter-bank borrowing spreads—pressure that has the potential to feed through and exacerbate the payment shock related to upcoming resetting of adjustable-rate mortgages in late 2007. In addition, it will take some pressure off borrowing costs for a wide range of consumers and businesses that have less than a top-tier credit rating. Finally, it reduces the effective cost of funds for banks, a necessary condition for banks to step in and provide a more substantial "on balance sheet" buffer to the shock waves unleashed by the collapse in the asset-backed commercial paper markets in August.

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