Fed trims key rate Cost of overnight loans to banks cut quarter-point to 5.25%

First reduction in 3 years

Wall Street hoped for deeper cut

Dow falls, then recovers

September 30, 1998|By William Patalon III | William Patalon III,SUN STAFF

The Federal Reserve cut a key interest rate a quarter-percentage point yesterday, the first such cut in three years and a move aimed at heading off a deepening world financial crisis that's already striking U.S. shores.

The Federal Open Market Committee, which sets interest rate and credit policies for the central bank, ratcheted back the target federal funds rate by one-quarter of a percentage point to 5.25 percent.

The Fed's action comes as Russia, parts of Latin America and much of Asia are in recession, and as big U.S. banks are being hit by losses from abroad and from highly risky investment strategies carried out by complex investment funds.

The cut was less than the half-point investors had hoped for: the Dow Jones industrial average plunged nearly 100 points after the midafternoon announcement, only to recover somewhat and close down by 28.32 points, at 8080.52.

"In terms of the global financial crisis, it wouldn't seem to be nearly enough" of a rate cut, said J. Patrick Bradley, chief economist at Mercantile Bankshares Corp.

"It's a down payment on an insurance policy and a little boost to the world economy."

The rate cut will likely result in lower borrowing costs on such things as cars and home mortgages -- which will put more spendable income in consumers' pockets and help keep the U.S. economy from slowing too severely.

However, it also will translate into lower returns on investments such as money-market accounts and certificates of deposit, meaning that those living on fixed incomes will feel more of a pinch.

But the rate cut's greatest significance may be symbolic: underscoring Fed Chairman Alan Greenspan's transition from avowed inflation-fighter and into central banker to the world.

"If the Fed is successful over the next six to 12 months, [it] will have acted as a 'shock absorber,' cushioning the ride so that the average person does not ever have to know how bad the pothole was -- and how bad the crash could have been," said G. David Orr, chief capital markets economist at First Union Corp. in Charlotte, N.C.

Walking the tightrope

It's money -- and the availability of that money -- that drives economic growth.

What Greenspan is trying to do is walk the tightrope between easy credit -- which could reignite inflation -- and the kind of credit crunch that helped push the U.S. economy into recession in the early 1990s.

"The action was taken to cushion the effects on prospective economic growth in the United States of increasing weakness in foreign economies and of less-accommodative financial conditions domestically," the Federal Reserve said in a statement.

"The recent changes in the global economy and adjustments in U.S. financial markets mean that a slightly lower federal funds rate should now be consistent with keeping inflation low and sustaining economic growth going forward."

Overnight loans

The Fed funds rate is what banks are charged for overnight loans and is the most sensitive indicator of the direction of general interest rates.

The overnight rate had been at 5.5 percent since March 25, 1997, when the Fed raised it by a quarter point, citing strong domestic demand that it feared might jump-start inflation.

The central bank cuts this rate by instructing the New York Fed to buy U.S. Treasury securities on its behalf -- increasing the "supply" of money with an infusion into the banking system while demand holds steady.

The Fed also could have -- but did not -- cut the "discount rate," the rate the central bank charges member bank for loans.

The discount rate held steady at 5 percent.

Impact of crisis

Yesterday's Fed decision continues to underscore just how seamless the world's financial markets have become, how a financial crisis in faraway Asia or Russia can have an almost direct impact on the life of a U.S. worker.

For instance, at a morning news conference today in Washington, Bethlehem Steel Corp. and the United Steelworkers America Union will announce trade case filings against countries they allege are "dumping" steel in the United States.

Dumping involves selling goods abroad at below cost to gain market share or to drive rivals out of business; it violates most trade laws.

Countries such as Russia and those in Asia with falling currencies and imploding economies are trying to export their way out of their miseries by selling their wares in healthy markets such as the United States in return for "hard" currency -- in this case, dollars.

Partly because the currencies of these countries have fallen so much in value, products from these foreign countries are in many cases priced far more cheaply than those made here.

That could force U.S. companies to cut prices to keep market share -- and maybe cut costs in the form of jobs in order to keep turning a profit.

Collapse of 'hedge' fund

The "Asian contagion," which has spread to Russia and parts of Latin America, is serious enough on its own to cause world financial problems -- and perhaps the feared credit crunch.

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