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Fed cuts rate, but recession worries persist

Many say action comes too late

Email|Print|Single Page| Text size + By Robert Gavin
Globe Staff / January 23, 2008

The Federal Reserve's surprising and unusually deep cut in interest rates yesterday signals the rapid deterioration of the economy while raising new questions of whether the central bank acted early enough to keep the United States out of recession, analysts said.

Lowering interest rates can boost the economy by lowering borrowing costs, encouraging consumers and businesses to spend. But many economists worry the Fed is acting too late, as recent data show consumer spending, hiring, and manufacturing stalling, if not contracting. It can take several months for the effect of lower rates to filter through the economy.

Wall Street, which has been clamoring for stronger action by the Federal Reserve for months, did not react as positively as markets in Europe to the Fed slashing its benchmark interest rate by three-quarters of a percentage point, the deepest single cut since 1982. The Dow Jones industrial average dropped 300 points in the first minute of trading before righting itself, and ended the day down 128.11 points, to close below 12,000 for the first time in 14 months.

Asian stocks rebounded after the Fed's action boosted banks. The MSCI Asia Pacific index added 2.7 percent to 135.64 early today in Tokyo, and Japan's Nikkei 225 stock average surged 3.5 percent to 13,062.41. And Australia's S&P/ASX 200 index jumped 5.1 percent, poised for its largest advance since October 1997.

The Fed, in reaction to panic selling in overseas stock markets on Monday, cut its rate at an emergency meeting of policy makers. The last time the Fed cut rates in an emergency meeting, following the September 2001 terrorist attacks, policy makers approved a half-point decrease.

The benchmark rate, which influences credit card, mortgage, commercial loans, and virtually every other borrowing rate, now stands at 3.5 percent, the lowest since August 2005. Many analysts expect the economy to weaken further and the Fed to cut rates to as low as 2.5 percent by spring.

"The Fed has to stanch the bleeding," said Scott Anderson, senior economist at Wells Fargo amp; Co. in Minneapolis. "Bad news feeds on itself, and that's what the Fed is trying to head off."

Some economists say the United States is in a recession. Others say it is heading there. Still others say the nation may skirt recession as falling interest rates and a proposed $140 billion federal economic stimulus plan provide a lift. Congressional Democratic leaders and President Bush said yesterday they could work together to soon enact a stimulus package, which could include tax rebates of $800 per individual, or $1,600 per household.

Still, economists said, millions of Americans won't be able to tell the difference between a recession - commonly defined as six months of declining economic activity - and near-recession.

The sharp economic slowdown could push unemployment, now at 5 percent, to 6 percent or higher, with each percentage point equivalent to about 1.5 million jobless workers, economists said. Home prices will continue to fall into next year, putting more stress on consumers and spending. Some sectors, such as housing, are already in recession.

"The real point is how long will this slow growth last, and when will we get back to normal?" said Rajeev Dhawan, director of the Economic Forecasting Center at Georgia State University. "This is going to be a long haul."

Many analysts, particularly on Wall Street, have urged the Fed to cut rates more aggressively over the past several months as the US housing crash infected global financial and credit markets. In December, when Fed policy makers last met, investors hoped the Fed would cut rates by a half point.

Instead, policy makers cut the rate by a quarter point, sparking a broad sell-off in stock markets. Eric Rosengren, the president of the Federal Reserve Bank of Boston, dissented from that decision, favoring a deeper rate cut.

Yesterday's bold action by the Fed, following steep losses in Asian markets, had a mixed impact in other markets. European stock markets, still open when the Fed disclosed its decision, rebounded from early declines and closed with gains. In the United States, stocks' losing streak continued.

Since the beginning of the year, the Dow has plunged more than 1,000 points, or about 10 percent. The index of 30 blue-chip stocks has lost more than 2,000 points, or 15 percent, since it peaked in October.

The stock slide has mirrored evidence of a rapidly deteriorating economy. Unemployment jumped in December; manufacturing activity contracted; housing starts plunged to their lowest levels since the recession of the early 1990s.

Economists said soaring oil prices, which briefly touched $100 a barrel, and a meltdown in housing, financial, and credit markets, are largely to blame for the downturn in the economy. But the Fed didn't recognize the extent of the economic slowdown soon enough, said Mark Zandi, chief economist at Moody's Economy.com, a West Chester, Pa. forecasting firm.

As a sharp slowdown loomed late last year, the Fed should have sent clear signals early on that it was ready to cut rates aggressively to prop up the economy, Zandi said. Instead, policy makers continued to raise concerns about inflation, a sign they were reluctant to cut interest rates to support growth. The result, Zandi said: eroding confidence among investors, businesses, and consumers.

"Once you get into one of these self-reinforcing downward cycles, it's hard to get out of it," Zandi said. "They've been reacting to events, and now they're trying to get ahead of them" with the three-quarter-point rate cut. But, he added, "it may not be enough to keep the economy out of recession."

Other economists said the Fed in December acted wisely in difficult circumstances - despite calls on Wall Street for deeper rate cuts. Inflation has been rising, partly as a result of soaring energy prices. If the Fed cut rates too far and too fast, it risked spurring so much demand that prices for goods and services begin to rise rapidly. A similar spiral sparked the runaway inflation of the 1970s, which ultimately force the Fed to raise rates sharply, leading to a deep recession in the early 1980s.

"Inflation could easily get out of control," said Jeffrey Frankel, an economics professor at Harvard University's John F. Kennedy School of Government. "The primary concern has to be the domestic US economy, and not the stock market. You have to guard against giving too much weight to Wall Street."

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

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