Fed cuts key interest rate half-point to 1 percent

UPDATED:

The Federal Reserve Wednesday slashed interest rates by another half percentage point to try to prop up sagging consumer spending while it agreed to extend short-term loans to the finance arms of all of Detroit’s Big Three automakers.

The central bank’s latest acts of largesse come as it has made scant progress at unfreezing locked credit markets that it says pose a serious danger to the economy and have been choking consumers and companies alike that are heavily dependent on credit. GMAC, the lending arm of GM, and its counterparts at Ford and Chrysler have been largely shut out of credit markets since mid-September, making it difficult or impossible to offer loans to consumers who want to buy cars.

The automakers’ sales have plummeted to the lowest levels in decades and GM has been fast running out of cash. Both GM and Chrysler — among the largest employers in the United States — are believed to be heading toward insolvency or bankruptcy next year unless their access to credit is restored or they receive help from the federal government.

The Fed has essentially agreed to become a lender of last resort to the auto companies, which have poor credit ratings. Using authorities not used since the Great Depression, the central bank already has taken on the role of lender to AAA-rated corporations like GE that issue commercial paper, as well as much of the entire financial system, including Wall Street firms and insurance companies.

The loans the Fed is making to corporations through the commercial paper program it started this week are unsecured — that is, the Fed does not take collateral in case the corporations are unable to make good on their loans. All of the auto companies have been downgraded far into junk credit status recently by Wall Street ratings agencies, which deem them to be among the shakiest credit risks. That is a major reason they have been unable to get loans in the private market.

While the auto companies are bankruptcy risks, they have unquestioned importance to the economy. By one estimate, one in ten American jobs are tied to auto manufacturing, the companies account for nearly nearly half of retail sales, and contribute powerfully to overall growth in the economy.

The Fed is in a very difficult position trying to protect the economy and revive moribund markets, and its actions show it is getting increasingly desperate, said Sung Won Sohn, economics professor at the University of California.

“The central bank is using the ‘Door Knob Policy’ where collateral requirements have been loosened significantly, i.e. the door knob could be used as collateral if necessary,” he said. “This is a very powerful tool; the Federal Reserve can lend money to almost anybody through the window and it does not require Congressional approval.”

The Fed’s move to slash the rate on overnight loans to banks by a half percentage point to 1 percent also shows the extremes it is willing to go to prevent a deep recession in the United States, Mr. Sohn said.

“The interest rate controlled by the Federal Reserve is headed to zero in a few months,” he said. “The willingness to lower the interest rate to something approaching zero is a very momentous decision. Rarely in its 95-year history, has the central bank put itself in this position. The Federal Reserve has to use everything it has to prevent the wild fire from growing.”

While the rate cut should help support confidence in financial markets and lower borrowing costs for consumers and businesses, it exposes a crucial problem as it leaves the Fed with very little room to lower rates further should the economic slump prove to be deep and long, Mr. Sohn said.

“The central bank could be viewed as an ‘Emperor With No Clothes’ as it runs short of ammunition,” he said.

The Fed said it was cutting rates out of concern about a sharp slowdown in consumer spending, which it said could be worsened by the turmoil in the stock market and freeze in credit markets in recent weeks. On Tuesday, the Conference Board reported that consumer confidence plunged by the most on record as worries about disappearing stock wealth and jobs surged to the forefront of consumer thinking.

Economists estimate that consumer spending, which fuels 70 percent of economic activity, is falling at a 2.5 percent rate after adjusting for inflation.

Even consumers who would like to spend are having trouble doing so because of a shortage of credit available from banks, the Fed noted. “The intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

The rate cuts and numerous other Fed maneuvers pumping money into the banking system this year have been aimed at restoring health to the credit markets and encouraging banks to lend more. Nevertheless, a monumental retrenchment in financial markets has persisted since mid-September, with only moderate responses to the Fed’s ministrations.

Financial markets responded mildly to the Fed’s rate cut, which was largely anticipated. The Dow Jones Industrial Average ended down 74 points.

Because of the pervasive fears that are freezing up financial markets, some analysts questioned whether the Fed’s rate cut would do much good.

“It does not address the leverage and credit issues in the banking system” which are stymieing lending, while it “penalizes savers,” who are earning miniscule interest rates on their savings deposits, said Martin Hutchinson, analyst at Breakingviews.com.

Joachim Fels, economist with Morgan Stanley, said the strenuous efforts of the Fed and other world central banks are needed, however, and eventually will bear fruit.

“Monetary policy will eventually get traction, though the timing is highly uncertain,” he said. “And if the policies used so far don’t work, we believe the central bank and government won’t shy awway from even more unorthodox measures.”

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