US acts to calm world economic jitters

Dramatic rate cut designed to avert global recession; Federal Reserve's intervention raises hopes of cut in UK rates
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The Independent Online

In today's traumatised global economy, one extraordinary day follows hot on the heels of another. The US slashed interest rates yesterday in a last-ditch attempt to avert recession in the world's largest economy and to try to restore order to the world's battered stock markets. The cut, by three quarters of a percentage point, was the largest in more than 25 years and was intended to signal to investors and corporations the world over that the Federal Reserve, the US central bank, would do everything it takes to reduce the cost of business and reignite the economy.

It certainly pepped up global stock markets, which had been in freefall across Asia and Europe and were threatening to suffer a full-on crash. Traders in the US had gone into work after the long weekend braced for the worst day since the New York Stock Exchange reopened after the September 11 terror attacks in 2001; then, with less than 90 minutes left before the opening of the market, the Fed announced an emergency rate cut that turned the situation on its head.

Last night the Dow Jones closed at 11,971.19, down 1 per cent, and the UK's FTSE 100 snapped back 161.9 points, almost 3 per cent, to close at 5,740.1. But the dramatic move unleashed as much criticism as support, and economists are calculating the long-term damage done to the reputation of the Federal Reserve, and its chairman, Ben Bernanke, by what appeared to be a panic move, forced on it by stock market traders rather than by the needs of the real economy.

Whether the US can avoid a deep recession – and whether it can avoid dragging the rest of the world with it – hinges as much on the outcome of that debate about the Fed's credibility as it does on the immediate impact of the cut. It could also hinge on an economic stimulus package under negotiation on Capitol Hill, and on whether it gets bogged down in political infighting. President George Bush met congressional leaders yesterday to negotiate a package of tax cuts and spending measures that will inject at least $150bn (£75bn) into the economy over the next few months.

The double-pronged strategy was welcomed on Wall Street and in the City of London, although many economists believe it has come too late. In Britain, the massive rate cut was followed by heavy hints from the Government that it may be advisable for the Bank of England to follow suit with a cut of its own. But the Bank indicated it had no intention of bringing forward the next monetary policy committee meeting, scheduled for 7 February.

Last night, the Governor of the Bank of England, Mervyn King, predicted that the coming year will pose the greatest economic challenges since 1997, with economic activity slowing "quite sharply" in the short term as consumers save more of their income. In a speech to members of the Institute of Directors in Bristol, he said: "There is a risk that weaker activity and lower asset prices could result in another round of losses for banks and a further tightening of credit conditions."

The Prime Minister's spokesman sought to calm fears, saying: "Britain remains well placed to withstand this uncertainty in the global economy. Of course we will have to remain vigilant ... we will take whatever action is necessary to maintain stability."

It was 8.20am, New York time, when the Fed said it would slash its main interest rate by three quarters of 1 per cent to 3.5 per cent, the first time since 9/11 that the Fed has intervened between its scheduled rate-setting meetings, and there is likely to be another cut at the next meeting a week today. The Fed has been boxed into bigger and bigger gestures because the credit crisisconvulsing financial markets since the summer, has made banks increasingly unwilling to lend, regardless of interest rates.

Neil Parker, market strategist at Royal Bank of Scotland, said: "Given that we were a week away from the Federal Reserve's meeting, the emergency cut smacks of panic. There is no way that they needed to cut 75 basis points if they were going to do a 75-basis point rate cut on 30 January. Rather than instilling confidence into the markets I think it will just throw in more panic, so we'll get a short-term rally, then most of the equity markets are going to get an absolute hosing again."

Michael Dicks, head of research at Barclays Wealth, said: "The risk for policymakers is that they become seen as ineffectual, and the Fed had itself already inferred that its past programme of interest-rate cuts has not been up to the task. We remain worried that the overly negative reaction of markets will become more and more self-fulfilling, polluting economic fundamentals."

The reductions are meant to lower the cost of borrowing so businesses feel comfortable investing in jobs and new production, and consumers have less of their income eaten in interest payments. Problems have been gathering since it became clear last year that millions of Americans were defaulting on mortgages in record numbers.

Before yesterday's rate cuts, global stock markets had been accelerating downwards, fuelled by concerns that a slump in demand from the US would hit all exporters. In their third successive night of large falls, Japan's market was down 7 per cent and Hong Kong was down 9 per cent.

The Bank of Canada responded to the Fed's move with an interest-rate cut of its own, and reductions are now likely in Asian markets such as Hong Kong where currencies are pegged to the US dollar. But in Europe, where there is almost as much concern over high inflation, it may be more difficult for central banks to follow suit.

In a sign of increased tension between the Bank of England and the Government, Mr King said inflation was so high he may have to write to the Chancellor to explain why he was missing the government target rate. That would make rate cuts in the UK impossible and keep the pressure on consumers and businesses reeling from the credit crunch.

Mr King also called for people to save more and issued a warning that the Government's spending levels could not continue.

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