Recession casts shadow over US interest rate cut

(Reuters)

The United States has slashed interest rates in the latest attempt to shore up the global banking system and prevent the world from sliding into a deep recession.

With financial markets still reeling from the collapse of Bear Stearns and banks increasingly refusing to lend money to businesses and potential homebuyers, the Federal Reserve acted to get the banking system moving again.

It was the second time since the start of the year that the Fed had shaved three-quarters of a percentage point from its target rate, bringing US interest rates down to 2.25 per cent from 4.25 per cent at the beginning of January, the fastest pace of reductions in years.

The latest cut was just the tonic beleaguered stock markets needed, and it fuelled a powerful rally on Wall Street, where the Dow Jones Industrial Average made its biggest one-day gain in six years.

Investors were betting that the Fed's actions would be enough to avert a full-blown banking crisis in the short term and then to restore some stability to the economy. Ahead of the announcement, the FTSE-100 of leading British shares had snapped back 3.5 per cent to 5605.8, recovering almost all of the £51bn losses from the previous day.

In more normal times, anything larger than a quarter-point cut in US interest rates would be considered an aggressive move, but the Fed signalled yesterday that these were not normal times. Indeed, it painted its bleakest picture yet for the US economy, raising concerns that the crisis could lead to knock-on problems for the country's main trading partners on this side of the Atlantic and in the emerging markets of Asia.

"Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters," the Fed said. It also expressed concern about weak consumer spending, which could hit business profits, and the even more worrying deterioration in the labour market.

Economists fear that a sharp rise in unemployment could trigger a new round of mortgage defaults, and send the credit markets on another downward leg. The Fed, under its chairman Ben Bernanke, has been fighting accusations from Wall Street that it failed to act fast enough last summer amid signs of distress in the credit crisis, making more drastic medicine necessary this year.

Most Wall Street traders had in fact been betting on a full percentage-point cut, but the Fed said the uncertain outlook for inflation – which could be stoked by the collapse in the value of the dollar – was still a problem.

The latest rate cut comes days after the Fed stepped in to orchestrate a bail-out of Bear Stearns, the fifth-largest investment bank on Wall Street, which is being sold for a knockdown price to its rival JPMorgan Chase. The Fed also ripped up decades of policy so that it could lend money directly to prop up investment banks, invoking a Depression-era law to allow it to do so.

Stock markets around the world rallied sharply as the bail-out appeared to alleviate the immediate crisis but economists said that growth may not resume in earnest unless there is a solution to the spiralling problems in the US housing market, where millions of Americans took out loans they cannot afford to pay.

President George Bush insisted the administration was on top of the crisis.

Arun Raha, an economist at Swiss Re in New York, described the Fed's action as "yet another forceful move in its attempts to alleviate the liquidity crunch and to shore up a rapidly weakening economy".