The Federal Reserve yesterday slashed interest rates by a surprisingly large half a percentage point to prevent the housing recession and credit crunch from causing a downturn in the economy.
VIDEO: Interest rate dropped, home sales up?
The rate relief, which prompted banks to quickly lower their prime rate from 8.25 percent to 7.75 percent, will help millions of homeowners with mortgages that are adjusting sharply higher to reflect rising short-term market rates, but probably comes too late to prevent another major leg down in the housing market, economists said.
The larger-than-expected rate cut set off a big rally in financial markets, with the Dow Jones Industrial Average soaring 336 points in its biggest gain in nearly five years. But the prospect of weak growth and lower interest rates in the U.S. sent the dollar to record lows against the euro and other currencies.
“The Federal Reserve Board has taken strong action to alleviate the market turmoil” by fulfilling the markets’ greatest hopes with a rate cut twice as big as expected, said Swiss Re’s chief U.S. economist Kurt Karl. But he still put the odds of recession at one in three because of the market turmoil and economic weakening that has already occurred, combined with record oil prices.
Oil prices have hit successive highs above $80 a barrel in recent days as the dollar weakened, setting the stage for high heating-oil prices and a difficult home-heating season ahead for debt-ridden consumers. Reports out yesterday also showed the housing market sinking to new lows, with foreclosures surging 115 percent to 243,947 last month, and home-builder sentiment dropping to an all-time low.
“This is just the beginning of a wave of new foreclosures,” Rick Sharga, executive vice president of marketing for RealtyTrac, a Web site that keeps track of bank seizures of homes. “There are lots of people who bought homes they could only afford at the teaser rates, and now have very few options.”
The Fed’s action will assist the estimated 2 million people in that position. The Fed said it was particularly concerned about an intensification of the housing downturn as a result of an acute credit crunch in the mortgage market.
While consumers have weathered the housing woes previously because of solid growth in jobs and incomes, a sudden drop in jobs last month signaled that the last major prop for the economy and consumers was falling away and led to the Fed’s forceful action yesterday, Mr. Karl said.
The disappearance of job growth during the summer “precludes any optimistic scenario for the U.S. economy,” he added. “Growth will be weak at best” and could give way to a short and shallow recession in the next year.
Lawrence Kudlow of Kudlow & Co. said the Fed did exactly what was needed to save the economy.
“They got this one right,” he said. “Adjustable-rate mortgage holders will get almost immediate relief. … Lenders will be more apt to lend, investors will be more apt to take risks,” and eventually the flagging economy will revive, he said. The rate cut also eases the credit crunch that has cut off access to loans for many finance companies and lower-rated corporations.
Richard Yamarone, economist with Argus Research Corp., said Fed Chairman Ben S. Bernanke overreacted and could be stoking inflation by resuming the easy money policies of his predecessor Alan Greenspan, which he said were responsible for the housing boom and bust.
“The Bernanke Fed just spiked the punch bowl,” Mr. Yamarone said. “Placating tantrum-tossing markets is bad monetary policy,” like giving candy to a “petulant child.”
The drop in jobs last month probably was “a fluke” and “the economy doesn’t need stimulus,” he contended. “Consumers are ringing cash registers at a steady pace, incomes are on the rise, U.S. factories are humming, farms can’t harvest fast enough, the service sector is booming, exports are rocketing.”
Downward pressure on the dollar is adding to inflation in oil and other commodity prices, however, fueling price pressures just as they were dying down, he said. A report from the Labor Department yesterday showed a 1.4 percent drop in wholesale prices last month and tame prices overall, led by a fall in oil prices. But oil prices more than reversed themselves this month.
Eliminating inflation was the Fed’s paramount goal only six weeks ago at the last meeting of its rate-setting committee. In the intervening time, it partially changed course at the onset of the credit crunch in mid-August by slashing its rate on emergency loans to banks. But the Fed continued to insist it would not provide a “bailout” for mortgage lenders who made risky loans. Mr. Yamarone said yesterday’s complete about-face makes the Fed board look like the “Keystone Kids.”
Harm Bandholz, economist with UniCredit Markets, agreed that the Fed faces criticism for bailing out financial investors with the rate cut while shelving lingering concerns about inflation.