Rate cut comes despite growth

The Federal Reserve yesterday cut its benchmark interest rate for the second time in as many months as it tries to contain the damage from the unraveling housing market.

The quarter-point cut in the federal funds rate came despite a Commerce Department report that the economy grew at its strongest pace in more than a year, even as the slumping housing market and accelerating mortgage defaults rattled financial markets. Policy makers, however, said in a statement they expect the economy to slow in the coming months as the housing market continues its slide.

Combined with the half-point rate cut in September, policy makers said yesterday's move "should help forestall some of the adverse effects on the broader economy that might otherwise arise from disruptions in financial markets and promote moderate growth over time."

The federal funds rate now stands at 4.5 percent, its lowest level since early 2006. The benchmark is the interest banks charge each other on overnight loans, but it influences virtually every other interest rate. The recent cuts mean lower borrowing costs for both businesses and consumers.

The Fed uses interest rates to manage the economy. It raises them to slow the economy when strong growth threatens to ignite inflation, and cuts them when growth slows to prevent recessions.

Yesterday's rate cut was welcomed by investors. The Dow Jones industrial average jumped 137.54 points to close at 13,930.01. The broader Standard and Poor's 500 index rose 18.36 points, to 1,549.38. The technology heavy Nasdaq Composite index rose 42.41 points to 2,859.12.

The Fed's move also helped push oil prices to another record high, since a faster growing economy boosts oil demand. Crude prices jumped $4.15 to $94.53 a barrel following the Fed's action and an earlier Energy Department report that US oil inventories dropped over the past week.

The Fed has moved aggressively in recent months to prevent housing and mortgage woes from pulling the rest of the economy into recession. Over the summer, credit markets almost melted down as losses from risky mortgages, known as subprime, mounted. That, in turn, raised fears that lenders and investors would cut off the credit and capital that the economy needs to grow.

Yesterday, however, Commerce reported that the economy grew at a surprisingly strong 3.9 percent annual rate in the three-month period ended Sept. 30. It was the economy's strongest performance since early 2006.

The Massachusetts economy, meanwhile, grew at a solid, but slightly slower 3.6 percent annual rate, the University of Massachusetts reported.

But, economists said, interest rate changes take several months to work through the economy, and the Fed needs to look ahead. Many economists expect the economy to slow dramatically over the next several months, sliding to a growth rate below 2 percent.

"A lot of shocks still have to come out of the housing market, which is still in free-fall," said Brian Bethune, US economist at Global Insight, a Waltham forecasting firm. "This is going to buffer that decline."

Still, economists said, the Fed probably doesn't have too many rate cuts left. In the statement disclosing the rate decision, policy makers said inflation still remains a risk, a signal that "the Fed is going to go slow in reducing rates," said Michael Moran, chief economist at Daiwa Securities America Inc. in New York.

Another indication that the Fed will move cautiously in cutting rates: Thomas Hoenig, the president of the Kansas City Federal Reserve, opposed yesterday's reduction. It's unusual for Fed policy makers to dissent.

"While not yet 'Mutiny on the Bounty,' " said Scott Anderson, senior economist at Wells Fargo amp; Co. in Minneapolis, "Tom Hoenig's vote is airing a growing minority view among central bankers that aggressive cutting of interest rates may create even bigger inflation problems down the road."

Rich Yamarone, the director of economic research at Argus Research Corp. in New York, said the Fed may already have done it. He said the Commerce report shows the economy is doing fine without extra stimulus from the Fed, even as rising energy and food prices add to inflationary pressures.

"The Fed slashing rates in this environment is kind of like watching your neighbor start up a barbecue with a gallon of gasoline and a Zippo," Yamarone said in note to clients. "You get the feeling that the Fed may be stoking one heck of an inflation inferno. "

Robert Gavin can be reached at rgavin@globe.com.