Fed cuts US interest rates by a quarter point

Greenspan acts to combat threat of deflation * Cost of borrowing falls to lowest level for 45 years

The US Federal Reserve cut its key federal funds rate by 0.25 of a percentage point to a 45-year low of 1 per cent yesterday. It warned that while the US economy was showing signs of improvement, it had yet to show it was firmly on path of growth.

In one of its most keenly awaited recent announcements, the Fed's policy-making Open Market Committee, headed by Alan Greenspan, went for the middle option of the three possibilities: a decision to hold rates steady, a quarter-point reduction, or a "bet the ranch" cut of half a percentage point, to get the economy moving.

In the event, the central bank chose the most widely expected and thus least disruptive route, voting 11-1 for a quarter-point cut. The lone dissenter was the FOMC member Robert Parry, who voted for a half-point cut.

The cut is the first since last November, but the 13th in all since the central bank embarked on its aggressive easing policy. The latest move brings the fed funds rate ­ the target rate for overnight interbank borrowing ­ to its lowest level since 1958, when Dwight Eisenhower was in the White House.

The immediate reaction of the markets was that the central bank has left the door open to a further quarter-point cut, perhaps at its next meeting on 12 August, should growth not pick up.

In its accompanying statement ­ this time if anything more anticipated than the rate reduction itself ­ the FOMC spoke of "recent signs that point to a firming" of the economy. But it warned, "the economy has yet to exhibit sustainable growth". With "subdued inflationary expectations" the moment was ripe for a cut, it added.

Wall Street fell on the news, with the Dow Jones index ending down 1.1 per cent. The dollar also slipped against the euro, falling to $1.1548 after the FOMC repeated its warning that "the probability, though minor, of an unwelcome substantial fall in inflation exceeds that of a pick-up of inflation".

Modest though it is, the reduction signals the Fed's determination to ensure the US does not drift into a deflationary cycle. The FOMC first raised a serious warning flag on deflation on 6 May, when it warned the risk of falling prices outweighed that of inflation.

The implication was that the US could be close to joining Japan (and, some now fear, Germany) in a long-term cycle of very weak growth, in which flat or falling prices cause consumers to defer purchases in the expectation they will become cheaper in the future, while the real cost of debt increases.

But since May the overall economic picture has slightly improved. Industrial production rose last month after two consecutive steep declines, while consumer prices held steady in May, defying expectations of a fall which would have reinforced deflation worries. Stock prices have rallied above 9,000 for the first time since August 2002, while the housing market is sizzling, as a result of historically low mortgage rates. New home sales soared 12.5 per cent in May, a record for a single month.

But the outlook remains precarious. Durable goods orders are weak, while first quarter GDP rose only 1.6 per cent, and growth for 2003 will do well to top 2.5 per cent.

The Fed move was fiercely debated beforehand, with some analysts arguing no cut was necessary, because the economy had already turned the corner, and that the danger of deflation is more imagined than real.

Economists surveyed by the Bond Market Association yesterday predicted annual growth of 3.5 per cent in the last six months of 2003, with better to follow in 2004. This group also expects business investment, the weakest component of national spending, to grow sharply again.

Opponents of a rate cut argue that the Fed would do better to keep its remaining powder dry, for use if growth fizzles out once more. With rates already so low, moreover, a further cut now will make little difference.