Federal Reserve cuts key rate 1/2 percentage point

by Frank James

In an attempt to loosen the credit crunch that's been tightening its grip on the economy, the Federal Reserve has announced that its cutting a key rate it charges banks for loans, the discount rate, by half a percentage point to 5.75 percent.

We'll know soon if this is enough to get the financial markets to stop what could be called their irrational gloominess of recent days as investors world wide have worried about the extent of the growing mortgage crisis in the U.S.

The Federal Reserve must be exceedingly worried about a possible recession to make this move now. Virtually every recent statement made by Fed officials, including Chairman Ben Bernanke, had indicated that the central bank's greatest worry was growing inflation, not slowing economic growth.

Here's how the Associated Press is reporting this morning's major news by the Federal Reserve.

By MARTIN CRUTSINGER, AP Economics Writer

WASHINGTON (AP) — The Federal Reserve, declaring that increased economic uncertainty poses risks for U.S. business growth, announced Friday that it has approved a half-percentage point cut in its discount rate on loans to banks.

The action was the most dramatic effort yet by the central bank to restore calm to global financial markets which have been roiled in the past week by a widening credit crisis.

The decision means that the discount rate, the interest rate that the Fed charges to make direct loans to banks will be lowered to 5.75 percent, down from 6.25 percent.

The Fed did not change its target for the more important federal funds rate, which has remained at 5.25 percent for more than a year.

However, it has been infusing billions of dollars in money into the banking system over the past week to keep that rate from rising above the target level.

Many economists believe if the financial market crisis worsens the Fed will soon move to cut the federal funds rate as well.

In a statement explaining the board's action, Federal Reserve Chairman Ben Bernanke and his colleagues said that while incoming data suggest the economy is continuing to expand at a moderate pace, "the downside risks to growth have increased appreciably."

White House deputy press secretary Tony Fratto declined to comment on the announcement but said, "We have full confidence in the Federal Reserve on these issues and respect their independence."

The Fed said it was "monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets."

The Fed said that "financial market conditions have deteriorated and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward."

The policy announcment was approved unanimously by the Federal Open Market Committee, the group of Fed board members in Washington and Fed regional bank presidents who set the federal funds rate.

Many economists have been calling for the Fed to move to cut the target for the federal funds rate, which has been at 5.25 percent since June 2006.

The discount rate covers only loans that the Fed makes directly to banks. But the funds rate covers all loans that banks make to each other on a short-term basis. It is much more critical in determining interest rates in the economy such as banks' prime lending rate.

The nation's once high-flying housing market is sinking deeper into gloom, and credit, the lifeblood of the economy, is drying up. Many economists believe these problems, including declining consumer confidence, could lead to a recession.

Since setting a record close of 14,000.41 just a month ago, the Dow Jones industrial average has shed 1,154.63 points in a string of triple-digit losing days that have raised anxiety levels not just on Wall Street but on Main Street as well.

The markets have been pummeled by a rapidly spreading credit crisis that began with rising defaults in subprime mortgages — home loans made to people with weak credit histories. Now the problems are spreading to other borrowers.

Countrywide Financial Corp., the nation's largest mortgage banker, was forced to borrow $11.5 billion on Thursday so it could keep making home loans. It was a move that rattled investors who have watched a number of smaller mortgage companies go under because of credit problems.

The shockwaves have extended to giant Wall Street investment firms such as Goldman Sachs, which announced earlier this week that it was pumping $2 billion into one of its struggling hedge funds. BNP Paribas, France's largest bank, last week froze three funds that had invested in the troubled U.S. mortgage market.

The Fed and other central banks already had infused the banking system with billions of dollars in an effort to keep short-term interest rates from surging and making credit even more difficult to obtain. However, those billions did not calm investors worried about which big hedge fund or mortgage company will be the next to announce serious problems. For that reason, investors have become fearful to supply money through credit markets to companies even if they have strong credit records.