Fed Cuts Its Discount Rate


Richard Moore

        The Fed, while not yet cutting a rate that wields more
        influence over the economy, moved to stimulate lending in
        part because it recognized that even well-to-do families
        with good credit ratings were having difficulty getting
        mortgages. That problem, radiating through the housing
        market and then the broader economy, had ³the potential to
        restrain economic growth,² the Fed said.

Original source URL:

August 18, 2007

Fearing Slide in Economy, Fed Cuts Its Discount Rate

The Federal Reserve, saying for the first time that the recent disorder in the 
financial markets has raised the risk of an economic downturn, took the unusual 
step yesterday of encouraging the nation¹s banks to borrow directly from the 
Fed, particularly to support home mortgage lending.

The early morning announcement of a drop in the so-called discount rate, made 
even before the stock market opened, sent Wall Street soaring as relieved 
investors celebrated the Fed¹s tacit acknowledgment that it had made a mistake 
last week in playing down concerns over the spreading distress in the credit 
markets. After falling for six straight days, the Dow Jones industrial average 
shot up 233.30 points, to 13,079.08, a 1.8 percent increase.

The Fed, while not yet cutting a rate that wields more influence over the 
economy, moved to stimulate lending in part because it recognized that even 
well-to-do families with good credit ratings were having difficulty getting 
mortgages. That problem, radiating through the housing market and then the 
broader economy, had ³the potential to restrain economic growth,² the Fed said.

The sudden action also suggested that the nation¹s central bankers were worried 
that a major financial institution might be at risk of failure if the Fed did 
not move before its policy makers gather for their next regular meeting, on 
Sept. 18.

Analysts predicted that the Fed was likely to go further, cutting market 
interest rates soon, perhaps even before its meeting next month if its action 
yesterday does not help to shore up confidence on Wall Street and elsewhere in 
the economy.

The mechanism for lifting the mortgage market was a cut of half a percentage 
point, to 5.75 percent, on borrowing from the discount window, a normally rare 
practice in which the Fed lends directly to banks facing some sort of trouble.

³We want to make it very clear that we are happy to lend,² one Fed policy maker 
said, ³and we are eager for banks to use the discount window.²

In a conference call yesterday, Fed officials told major banks that discount 
window borrowing would be viewed as a sign of strength, not weakness.

Just the way in which the Fed acted showed how quickly its previous concerns 
about the greater risk of inflation had evaporated. The Fed¹s standard practice,
for more than a decade, has been to change rates and issue statements only at 
scheduled meetings of policy makers. Inter-meeting actions only underscore the 
dire nature of the situation.

But as stock prices moved wildly once again on Thursday, the Fed¹s chairman, Ben
S. Bernanke, convened a 6 p.m. teleconference call, and after an hour of 
discussion, the 10 policy makers present voted unanimously for the discount rate
cut and for an assessment of the economy clearly more negative than the upbeat 
one issued just 10 days earlier.

That earlier statement, issued after the Fed¹s Aug. 7 meeting, said that the 
economy ³seems likely to continue to expand at a moderate pace over coming 
quarters.² The new description repeated the view that the economy would expand 
at a ³moderate pace,² but added ³that the downside risks to growth have 
increased appreciably.²

William Poole, president of the Federal Reserve Bank of St. Louis, was missing 
from the conference call and Fed officials explained carefully to reporters that
he was absent only because of a conflict with a long-scheduled dinner 
appearance, adding that suddenly canceling that appearance might alarm the 
marketplace. Mr. Poole has publicly opposed a cut in the federal funds rate.

Indeed, no change was made yesterday in the more important federal funds rate, 
which the Fed uses as its main policy tool, cutting it to stimulate a flagging 
economy or raising it to rein in a potentially inflationary one. Still, 
yesterday¹s action suggested that the funds rate itself ‹ which directly affects
what businesses pays for loans and what ordinary Americans pay for home equity 
borrowing, car loans and various other consumer credit ‹ would soon be cut.

³What the Fed is really saying is that this recovery is more in danger than it 
has been since it started nearly six years ago,² said Jan Hatzius, chief United 
States economist for Goldman Sachs, who predicted an initial cut in the funds 
rate to 5 percent, from the present 5.25 percent.

The discount move, coupled with formal acknowledgment that the economy might be 
in trouble, represents Mr. Bernanke¹s boldest attempts to relieve the financial 
crisis, his first real test since becoming Fed chairman 18 months ago.

The Fed¹s admission that the economy might not be so healthy suggested to Mr. 
Hatzius and others on Wall Street that an initial cut in the federal funds rate,
which has been at 5.25 percent for nearly 14 months, could be followed by 
several more in the months ahead as the Fed braces for the possibility of a 
weakening economy, dragged down by a shrinking housing market.

³This is a watershed statement from the Fed to let the markets and politicians 
know that the Fed is prepared to act as needed,² Stuart G. Hoffman, chief 
economist at PNC Financial Services Group, wrote in a note to clients.

Fed policy makers and Treasury officials said that in cutting the discount rate,
the Fed¹s principal goal was to shore up the market for creditworthy mortgages, 
including those for more expensive homes.

While that market is primarily for more affluent borrowers, Fed officials said 
they were worried that average Americans would suffer, too, if the troubles in 
the so-called jumbo mortgage market infected the rest of the economy. The 
collapse of so many subprime mortgage securities had spread to the larger 
market, and lenders of high-quality mortgages were having trouble selling the 
loans they made.

So the Fed said to the banks in effect: borrow at the discount window, using the
mortgages as collateral, at a rate of 5.75 percent, down from 6.25 percent. 
Moreover, banks were encouraged, if necessary, to roll over the loans every 30 
days, an easing of the usual 24-hour rule.

That brought the discount window into the financial crisis, which the Fed, until
yesterday, had dealt with in a different manner. It did so by adding billions of
dollars to the banking system, to keep the federal funds rate at 5.25 percent. 
This is the interest that banks and other lending institutions pay to borrow 
from each other to finance their operations.

In the midst of the crisis, the federal funds rate spiked to a level above 6 

Cutting it will inevitably raise the charge that the Fed is bailing out hedge 
funds and others who borrowed billions of dollars to invest in subprime 
mortgages, ignoring the risk that many of the low-income households who got 
these mortgages would default.

Lower interest rates raise the odds that risk takers can sell bad investments 
with less of a loss.

³You would be mitigating their problems,² said Alan Blinder, a Princeton 
University economist and a former Fed governor, but ³I would count that as a 
social cost of saving the economy.²

What remains unclear is how much damage, if any, the economy has suffered from 
the market turmoil. The Fed promised ³to act as needed to mitigate the adverse 
effects,² but data documenting any damage takes weeks to collect.

Home construction is clearly down, and recent economic reports show that 
consumption has weakened since the first quarter.

³If there was evidence of a significant decline in spending, that would induce 
the Fed to cut rates, but there is no evidence of a significant decline in 
spending,² said Mark Gertler, a New York University economist who did research 
with Mr. Bernanke when the Fed chairman was a Princeton professor.

The earliest damage would show up in consumer sentiment. The University of 
Michigan¹s Survey of Consumers released a poll yesterday showing that Americans 
were somewhat more pessimistic because of costly food and fuel, not the 
unfolding financial crisis. ³People have not yet begun to calculate how the 
market turmoil might affect their own situation,² said Richard T. Curtain, 
director of the Michigan survey. ³That is still in the future, if it ever 

Steven R. Weisman contributed reporting.

Copyright 2007 The New York Times Company

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