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Economic quicksand

Fed may decide to make rare 1% interest rate cut; Analysts call step far from cure-all

Email|Print|Single Page| Text size + By Robert Gavin
Globe Staff / March 18, 2008

The Federal Reserve could make one of the biggest interest rate cuts in its history today as it tries to jolt the US economy from a financial crisis that has so far resisted all efforts to solve it.

Many economists expect Fed policy makers to cut the central bank's key interest rate by 1 percentage point, but they worry even this reduction won't halt the erosion in confidence undermining the economy. Lower interest rates, which aim to boost the economy by enticing consumers and businesses to borrow and spend, provide little help if lenders aren't loaning money out of fear they won't be repaid.

"Banks are calling in loans, not making them," said Gus Faucher, director of macroeconomics at Moody's Economy.com in West Chester, Pa. "The traditional monetary policy of cutting interest rates isn't very effective in this environment."

The Fed has taken a number of extraordinary steps recently to shore up the economy and keep the nation's financial markets from freezing up from a lack of capital. On Sunday, it moved to prevent the collapse of Wall Street firm Bear Stearns Cos., by approving its sale to a rival investment bank, and providing as much as $30 billion in backing for some of Bear Stearns assets. But now analysts said the central bank may be reaching the limit of its powers because of eroding confidence.

Consumer spending is responsible for more than two-thirds of US economic activity, but consumers are unlikely to borrow if they are worried about losing jobs. And lower mortgage rates don't provide much of an enticement to buyers worried that home values are going to continue to fall.

"It's the lead-the-horse-to water argument," said Rich Yamarone, director of economic research at Argus Research Corp. in New York. "You can cut the rates to nothing, but you're not going to solve the problems, which are distrust and fear."

Deeper interest rate cuts hold other dangers, such as further weakening the dollar and igniting inflation. The dollar has fallen along with interest rates, losing value against currencies in countries with higher interest rates, and hence, higher returns.

As the buying power of the dollar has shrunk, it has helped drive up the price of oil, putting further strain on consumer spending, and contributing to inflation as businesses pass along higher energy costs. Oil trades in dollars, so as the dollar slips, producers demand higher prices to make up for the decline in value.

The Fed has cut its benchmark rate by 2.25 points since September, but the economy has continued to deteriorate. Most economists believe the United States has entered a recession, and many increasingly expect it to be longer and deeper than the recessions of 2001 and the early 1990s, both of which lasted eight months. Private employers nationwide have cut jobs in each of the past three months, the Labor Department recently reported.

The benchmark rate influences virtually every other interest rate, from credit cards to mortgages, and economists expect policy makers to chop the benchmark by at least three-quarters of a point today, and as much as 1 percentage point. That larger reduction would bring the rate as low as 2 percent, the lowest since November 2004. It would also mark the first time the central bank has cut a full percentage point in one shot since 1982, when the rate stood at about 11 percent.

"You have a very sick patient," said John Silvia, chief economist at Wachovia Corp. in Charlotte, "and it's shock therapy."

A one-point cut would be the latest in a series of drastic measures aimed at halting a rapid deterioration of financial markets and the economy, driven by the plunging US housing market and increasing mortgage defaults and foreclosures. Large Wall Street firms have sustained huge losses from investing in securities backed by subprime mortgages and other risky loans, and that has infected financial and credit markets as investors and lenders become reluctant to lend and invest.

Over the weekend, the Fed took two extraordinary measures to contain the damage from the latest victim of the so-called subprime crisis, investment bank Bear Stearns. First, the Fed helped broker Bear's sale to JPMorgan Chase & Co., and then said it would make Fed loans directly available to securities firms for the first time in the central bank's history.

The idea is to bolster confidence that these firms will have access to enough cash to keep operating through this difficult period. If lenders and investors worry these firms are running out of cash, they could quickly pull out their money, spurring events similar to bank runs that could cascade through the financial system and worsen the downturn.

The Fed has also pumped hundreds of billions of dollars into the financial system, cutting the rates it charges banks for short-term loans and taking highly rated and low-risk mortgage backed securities as collateral. These securities, however, remain hard to sell in open markets.

But investors remain wary because it is not clear whether the worst of the subprime mortgage crisis is over, analysts said. It could still take several months before the full extent of losses from mortgage-backed holdings becomes known.

Stocks struggled yesterday in another see-saw session. The Dow Jones industrial average fell nearly 200 points during the session, but climbed back to gain 21.16 and close at 11,972.25. The technology heavy Nasdaq composite index fell 35.48 to 2,177.01.

Robert Gavin can be reached at rgavin@globe.com.

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