Another Fed cut: A rock ... Bernanke ... and a hard place

WASHINGTON -- The Federal Reserve pushed on with the most aggressive series of interest rate cuts in decades Wednesday, slicing a key rate by half a percentage point and signaling that more reductions are possible if housing and credit markets fail to revive.

Those actions followed an emergency meeting last week when the Fed slashed the federal funds rate, its key policy tool, by three-quarters of a percentage point. Since September, the Fed has cut the rate from 5.25% to 3% to ward off a possible recession. The 1.25-point cut over the past nine days is the steepest in such a short time period since at least the early 1980s and appears to be unprecedented in recent central bank history.

The Fed's policymaking Open Market Committee in a statement said financial markets were "under considerable stress" while credit had tightened for some businesses and households. It said the housing sector had worsened and pointed to "softening" in labor markets. Fed officials gave just a nod to inflation, saying that while they expect price pressures to ease in coming months, they will "remain vigilant."

The Fed softened its rhetoric a bit from previous statements, taking out an earlier reference to "appreciable" risks to the economy. But while saying its rate cuts should promote moderate expansion over time, it added that "downside risks to growth remain" and promised to "act in a timely manner as needed to address those risks." That suggests more rate cuts could be on the way.

The Dow Jones industrials, which jumped more than 200 points after the announcement, finished down 37.47 at 12,442.83. The dollar fell to a two-month low as traders worried more rate cuts could be on the way.

The Fed rate cut came as the Commerce Department reported that the economy very nearly stalled in the final months of last year. Gross domestic product, the broadest measure of goods and services produced in the nation, grew at a weak 0.6% annual rate in the fourth quarter of 2007, down from a 4.9% pace in the third quarter. The economy grew just 2.2% last year, the most anemic performance since 2002, when businesses struggled to recover from a recession. Consumer spending, more than two-thirds of the economy, is slowing.

The White House and Congress have jumped in as the outlook has deteriorated. The House on Tuesday passed a bipartisan stimulus bill containing about $150 billion of personal and business tax cuts. The Senate is working on its own version, including more generous unemployment benefits. In a speech Wednesday, President Bush prodded the Senate to quickly pass the House measure.

"Whatever the Senate does, they should not delay this package, they should not keep money out of your pocket," Bush said. "The sooner you get a check, the more likely it is" that the economy will start to revive.

While Fed rate cuts take months to work through the economy, consumers could see some near-term effects. The fed funds rate, what banks charge each other for overnight loans, is a benchmark for much consumer lending. As the Fed has moved, the average rate for a variable-rate credit card has fallen to 13.1% from 14% in September, according to Bankrate.com. Wednesday's action will push that down more. Big losers will be savers who rely on certificates of deposit for income.

And more cuts could be on the way. In a recent survey for USA TODAY, gci the median forecast of 51 leading economists was that the Fed would reduce short-term rates to 2.75% by midyear.

Second-guessing Bernanke

The rate cut and fresh data escalated the sharp debate about whether Fed Chairman Ben Bernanke, who marks his two-year anniversary as head of the central bank Friday, is pursuing the right strategies.

Bernanke, a soft-spoken former academic, has come under harsh scrutiny. The heated rhetoric in part reflects the unsettled and unusual economic conditions the central bank faces. The housing market is in a free fall due to reckless lending and lax regulation. International financial markets are increasingly complex and opaque, making it hard to identify and price risks. Strong world growth has pushed prices of oil, grains and other commodities to historic highs, which can simultaneously depress growth and fan inflation.

Like many economists, the Bernanke Fed was slow to recognize the extent of the housing downturn and its impact on financial markets. Concerns about the soundness of mortgage-backed bonds last summer morphed into a full-blown credit crunch.

But in recent weeeks the Fed has moved into an aggressive crouch. The result? New concerns that the Fed is reacting to the markets or is moving too fast, possibly sparking inflation.

"I would not want to be in his (Bernanke's) shoes. This is a pretty treacherous time to be at the helm at the Fed," says Sean Snaith, director of the Institute for Economic Competitiveness at the University of Central Florida. Still, Snaith, more worried about possible inflation than slower growth, says Bernanke has been too willing to cut rates to appease the stock markets. The Fed's surprise announcement of a three-quarter-point rate cut on Jan. 22, as overseas markets plummeted in waves of panic selling, "really seems directed at Wall Street rather than addressing a slowdown in economic activity," Snaith said. "We count on the Fed looking at the long run, not the short run."

Mark Gertler, an economics professor at New York University who has collaborated on research with Bernanke, says the Fed is taking too much flak.

Last week's steep rate cut was necessary and consistent with Fed warnings about deteriorating economic conditions. It was in line with Bernanke's work on the Great Depression, when breakdowns on Wall Street worsened conditions on Main Street, Gertler says. The central bank was also pivotal last fall when it made financing available through its so-called discount window as credit markets began to freeze up.

"What I most marvel at, there's two instances where they (Fed) managed to avoid a financial crisis and they don't seem to be getting much credit for that," Gertler says. "The Fed can't fine-tune. Its (mission) is to avoid disasters like the Great Depression or the great inflation of the '70s. That's where the Fed is coming from."

In a sign of how sensitive the situation is, House Financial Services Committee Chair Barney Frank, D-Mass., issued a statement Wednesday backing off quotes in a news story critical of Bernanke.

"This is a very difficult time for our economy, and unbalanced and unfair criticism of Mr. Bernanke is therefore not simply a matter of his feelings, but of potentially, even if inadvertently, undermining the confidence people must have in the public policy response," Frank said. "I am on the whole favorably impressed with Chairman Bernanke's role at the Fed."

There is division within the central bank. Dallas Fed President Richard Fisher on Wednesday became the latest in a string of Fed officials to dissent from the policy move, instead favoring no change in rates.

Just how bad is the economy?

Part of the unease also stems from widely different views on how serious the current situation is. The overall economy slowed late last year, but orders for big-ticket durable goods unexpectedly expanded in December. Exports are strong, and the farm sector is thriving. Unemployment has risen, but it was just 5% in December. The Labor Department will release January's unemployment report Friday. Some economists expect only a mild turndown or say that efforts by the Fed to artificially prop up the economy will only delay necessary corrections in housing prices.

Dana Johnson, chief economist at Comerica Bank cma in Dallas, says there appears to be a consensus in monetary and budget policy on pulling out all the stops, though, "I don't understand that consensus."

"House prices had gotten unsustainably high; we have to let them fall back," says Johnson, who worked at the Fed earlier in his career, adding the nation might need to "accept" a recession.

There is also concern that the Fed is not paying sufficient attention to spiking oil, food and other commodity prices. The Fed's preferred inflation measure of core inflation excludes volatile food and energy prices. Even so, it rose 2.7% at the end of 2007, up from 2% in the third quarter.

Others say tough action is warranted. If the economy does fall into a recession, it could be a prolonged, painful affair, given falling asset prices and shrinking lending capacity as banks write off huge losses and hold more loans on their books. New-home sales have plummeted more than 40% from a year ago, and prices are down more than 10%. That not only affects construction employment and spending, it hurts consumers, because homes are their main form of wealth.

"The housing sector is in serious trouble, even worse than we supposed," Harvard economist and former Clinton Treasury secretary Larry Summers told a House committee this week. Summers cited a possible scenario "in which the economy turns down, exacerbating problems in the banking system, which causes the economy to turn down further. (We're) running a risk of having the type of situation that plagued Japan during the 1990s," with years of sluggish growth.

Brian Bethune, economist at consulting firm Global Insight, calls credit conditions "extremely restrictive," forcing the Fed to make deep rate cuts. Even if Congress acts quickly, fiscal stimulus won't kick in until the second half of the year. "That is a long five months in today's volatile climate for financial markets," he says.

There is growing acknowledgment that Washington has to do more to address structural problems in the economy that can't be solved by Fed rate cuts. Congress hopes to help homeowners who now owe more on their mortgages than their homes are worth.

That's not to say rate cuts won't have an impact. Big banks on Wednesday cut their prime rate to 6.0% from 6.5%. Some lenders announced fixed-rate home mortgages as low as 5.5% for borrowers with good credit.

Homeowners with home-equity lines of credit will see their rates decline, because those loans are typically tied to the prime rate. Last week, the average rate for a home-equity line of credit was 7.3%.

Homeowners who haven't already tapped their home equity will have a hard time getting a new line of credit or home-equity loan, says Jim Svinth, chief economist for LendingTree.com. Lenders have tightened standards. Even borrowers with good credit could pay more for a new home-equity line, he says. But, "If you already have one and have an outstanding balance, your cost of financing is going down."

Interest rates for CDs already lag behind inflation and are expected to drop even more after Wednesday's rate cut. The average yield for a 1-year CD fell to 3.13% last week, down 0.19 percentage points from the week earlier, Bankrate.com says. Savers can get better rates by shopping around, but rates on high-yield CDs, which are often offered by online and regional banks, are falling, too. The online rate for Countrywide Financial's 1-year CD has dropped to 4% from 5.65% in August.

One certainty: Volatility is far from over.

"I couldn't think of a worse job to have" than being Fed chairman or a Senate leader, says Tucker Hart Adams, owner of The Adams Group in Colorado Springs.

Contributing: Sandy Block