Surprise: Fed slices rates by a half-point

WASHINGTON -- The Federal Reserve cut interest rates a half-percentage point Tuesday in a dramatic bid to shore up confidence in the economy and ease worries about a credit crunch in financial markets.

Fed Chairman Ben Bernanke and his colleagues unanimously voted to lower their target for short-term interest rates, which influences a wide variety of borrowing costs, to 4.75% from 5.25%. The cut was the first from the Fed in more than four years and followed 15 months of steady rates from the central bank.

In their post-meeting statement, Fed policymakers said the credit squeeze "has the potential" to sharpen the housing decline and harm the larger economy. They said turmoil in financial markets had "increased the uncertainty" about the economic outlook.

"Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time," they wrote.

The Fed on Tuesday also cut the discount rate, the rate it charges banks for direct loans, by a half-percentage point, in a move to facilitate lending. A month ago, the Fed, in a rare move, cut the discount rate, which usually moves in tandem with the Fed's main interest rate lever, to help ease the credit crunch.

Financial markets moved sharply higher in response to the Fed move Tuesday, with the Dow Jones industrials adding more than 100 points within minutes of the Fed announcement. They closed up more than 300.

For consumers, the Fed move is "good news generally for short-term borrowers, not as good of news for short-term savers," says Bob Walters, chief economist at Quicken Loans. What it means:

• Banks immediately cut the prime rate, base rate for many business and consumer loans, such as home equity lines of credit and credit cards, from 8.25% to 7.75%. That means that someone with a home equity line of credit of $50,000 at prime will see their monthly payment fall $20 to $322 per month, Walters says.

• Credit card interest rates may fall, although probably not dramatically and will be more based on an individual's credit history.

• Rates on adjustable-rate mortgages likely will fall. People who have ARMs with rates that are resetting in coming months should "see some relief," Walters says.

• For consumers shopping for fixed-rate mortgages, there probably won't be much change from current rates. That's because such mortgages are tied to 10-year Treasury yields. Those yields have fallen in recent weeks as investors have flocked to the safer investment vehicles. The 10-year yields fell immediately following the Fed's announcement.

The average rate for a 30-year, fixed-rate mortgage was 6.31% last week, down from 6.46% the previous week and 6.43% a year ago, according to Freddie Mac.

• Savers will likely lose out, however, because interest rates on certificates of deposit and other low-risk investments will decline.

But "on balance, there are more winners than losers," Comerica Bank chief economist Dana Johnson says.

The Fed had not moved rates by half a percentage point since November 2002, opting instead for more gradual, quarter-percentage point moves since June 2003, when the Fed last cut rates. The U.S. central bank moved in quarter-point increments each of the 17 times it raised rates from June 2004 to June 2006.

An interest rate cut from the Fed on Tuesday was widely expected by economists and investors after the meltdown in the subprime mortgage market led to turmoil in financial markets around the globe.

But investors and analysts were divided on how big a cut to expect. Those arguing for the larger, half-percentage point cut, such as Joel Naroff of Naroff Economic Advisors, argued that problems on Wall Street were spreading to Main Street, posing a risk the economy will sag.

"Bold action was needed to deal with the rapid evolution of events in the past several weeks in the economy and the financial markets, and bold action is what the Fed delivered," says Brian Bethune, U.S. economist at Global Insight.

But First Trust Advisors chief economist Brian Wesbury says the Fed was using a "very broad tool to try to fix a specific problem," namely a problem in the subprime housing market that was not threatening the overall economy. The Fed cut will only stoke price pressures and force the Fed to raise rates swiftly to arrest inflation, he says.

"This is a move to try and calm market fears, but it is a move that will have little effect on the economy and in fact will lead to further rate hikes and potential problems with inflation down the road," Wesbury says.

The number of payroll jobs in the USA fell for the first time in four years in August while surveys of consumer and business confidence have declined. The housing market continues to slide. And the increase in oil prices to record levels in recent weeks could lead to higher energy bills for consumers and businesses, forcing them to cut spending elsewhere.

Still, other data point to healthy retail sales, manufacturing activity and exports, leading to a mixed picture of the U.S. economy.

Fed policymakers had continued to express concern about inflation until recent weeks, but good news on the inflation front came Tuesday morning, giving the Fed greater latitude to cut interest rates.

The Labor Department said its producer price index, a measure of wholesale inflation, fell 1.4% in August, sharpest decline in 10 months. The drop was led by a drop in energy costs.

But even excluding volatile food and energy prices, wholesale prices the past 12 months were up 2.2% in August vs. 2.3% in July.