Fed Trims Rates Again, Hints at Further Cuts
By John M. Berry
Washington Post Staff Writer
Wednesday, October 3, 2001; Page A01
Federal Reserve policymakers, citing the damage caused by the recent terrorist attacks to the stalled U.S. economy, yesterday cut short-term interest rates for the ninth time this year and signaled that they may well reduce them again to help ease the coming financial pain.
Meeting as the nation appears to be sliding into recession, Fed officials cut their target for overnight interest rates another half-percentage point yesterday, to 2.5 percent, the lowest level since the central bank began targeting the key rate in 1988.
Since the Sept. 11 airline hijackings, consumer confidence has continued to crumble, stock prices have plunged and companies have announced more than 100,000 layoffs. Some government officials and analysts have worried openly that the economy's biggest problem at the moment is fear -- businesses afraid to invest at a time of shriveling demand, consumers afraid to make big purchases as unemployment rises, and many people still afraid to fly.
"The terrorist attacks have significantly heightened uncertainty in an economy that was already weak," the Federal Open Market Committee, the central bank's top policymaking group, said yesterday in a statement, noting the extraordinary psychological blow to the economy suffered in recent weeks. "Business and household spending as a consequence are being further damped."
In such a climate, some analysts and government officials have worried that the Fed's efforts to lower borrowing costs may do little to induce more spending.
The rate reductions are unlikely to prevent a recession at this point, analysts said, but they may help ease the effects of it by making the downturn less severe and shorter than it would otherwise have been.
Likewise, many analysts hope the economy will benefit from an expected $100 billion in increased federal spending and tax cuts being negotiated by the White House and Congress.
Given all the government effort to stimulate the economy, the recession will be "relatively shallow and relatively short-lived," said Wayne Ayers, chief economist at FleetBoston Financial Corp.
Some forecasters are more sanguine about the economic outlook than Ayers is. But many are more pessimistic, worrying that government action that would boost growth in normal economic times may not be enough to overcome the anxieties raised by an indefinite and costly global war on terrorism.
Indeed, for some types of borrowing, interest rates have gone up despite the Fed's huge cuts in short-term rates. Rates on corporate bonds, particularly "junk bonds" issued by less-creditworthy companies, have climbed as investors have become less willing to hold more risky assets.
That causes problems for many companies that have seen their profits and cash flow fall sharply over the past year. As a result, companies' financing gap -- the difference between what corporations need to finance their capital investments and the cash flow they have available -- is now running at an annual rate of more than $250 billion, said Bill Dudley, chief economist at Goldman Sachs Group Inc.
But the Fed's action yesterday does make it cheaper for financial institutions to borrow, and they can lower rates for their customers. Major banks followed yesterday's Fed move by cutting their prime lending rates from 6 percent to 5.5 percent, the lowest level since Oct. 3, 1972. The rates banks charge on some personal loans, such as home-equity loans, and many small-business loans are tied to the prime, so such borrowers' costs will fall.
Rates charged on many unpaid credit card balances may not fall because, although they are also tied to the prime, they do not fall below a certain floor, which had already been reached.
The effect on rates for 30-year fixed-rate home mortgages is less clear. Those rates usually track changes in longer-term interest rates that are determined by forces in the financial markets. But mortgage rates generally are already below 7 percent across the country, and a number of analysts said yesterday's Fed action may have little effect on them.
The Fed action also helps assure financial markets that the central bank will provide enough money to keep markets operating smoothly. After a day of wide swings, the major stock indexes closed up about 1 percent yesterday. The Dow Jones industrial average rose 113.76 points, to 8950.59; the Nasdaq composite index advanced 11.87, to 1492.33; and the Standard & Poor's 500-stock index was up 12.78 at 1051.33.
With U.S. financial markets disrupted immediately after the attacks, the Fed pumped unprecedented amounts of cash into the nation's banks to keep the financial system operating. Then on Sept. 17, the Fed lowered its key rate target by half a point, to 3 percent. Gradually the stock and bond markets began to operate more smoothly, though neither is fully back to normal.
Fed officials also indicated yesterday that they are likely to further trim the federal funds rate, the interest rates financial institutions charge one another on overnight loans, perhaps as soon as their next meeting on Nov. 6. Even though that rate is already a full 4 percentage points lower than it was at the beginning of the year, the committee said "the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future."
The federal funds rate has not been so low since 1962, but before 1988 it was not targeted by the Fed as a tool for influencing the economy's course. Many analysts expect the Fed to lower the target to 2 percent by the end of the year.
The Fed also cut its discount rate, the interest rate financial institutions pay when they borrow money directly from one of the 12 regional Federal Reserve banks, by half a point, to 2 percent, the lowest level in more than four decades. That rate is largely symbolic in normal times, but in the aftermath of the attacks, when the banks had to borrow tens of billions of dollars from the Fed, that rate was suddenly important.
Ayers predicted the economy will contract at a 2.5 percent annual rate this quarter and at a 0.8 percent rate in the first three months of 2002 before growth resumes. Under that forecast, the total drop in the gross domestic product would be less than 1 percent.
A slump of that magnitude and duration would be only about half that of the last recession, in 1990-91. But it would drive up the nation's unemployment rate, which was 4.9 percent in August, close to 6.5 percent by the middle of next year, Ayers said.
And the more pessimistic forecasters note that every additional percentage point of unemployment translates into about 1.4 million more jobless Americans, which can fuel continued consumer anxiety.
In such an environment, even some Bush administration officials and lawmakers are concerned that new tax cuts would boost savings more than spending. For instance, in August tax refunds helped push disposable personal income -- essentially after-tax income -- upward by 1.9 percent. But personal-consumption spending rose only 0.2 percent that month.
And rate cuts are not good news for all investors. As short-term interest rates have come down this year, so have the rates most financial institutions have been willing to pay on money-market deposit accounts and certificates of deposit. For instance, the Commerce Department reported Monday that personal interest income has been declining since early this year.
Bankrate.com, a service that tracks consumer rates, reports that across the country rates on CDs with maturities ranging from three months to five years are at their lowest levels since the firm started tracking them in 1984 -- and Bankrate expects them to fall further.
Worse, real rates of return -- what a security pays after subtracting inflation -- have declined even more, according to Greg McBride, an analyst with Bankrate.com
Gregory D. Sullivan of Sullivan, Bruyette, Speros & Blayney Inc., a financial planning firm based in McLean, said: "It can be devastating on retirees. They are coming out of CDs that were paying 6 or 7 percent and counting on this income for retirement. Now they are looking at CDs [paying] in the 3 1/2 percent range, so their income is cut in half. If they are relying on that income for food and to pay utility bills, it's going to be pretty harsh on them."
Staff writer Albert B. Crenshaw contributed to this report.