Fed Cuts Key Interest Rate as Global Markets Drop for Second Day | January 22, 2008

By Howard Schneider, Neil Irwin and Ariana Eunjung Cha

Washington Post Staff Writers
Tuesday, January 22, 2008; 10:33 AM

The Federal Reserve cut a key U.S. interest rate by three-quarters of a percentage point this morning as a global stock sell-off continued on Wall Street today, with the Dow Jones industrial average dropping more than 400 points in its opening minutes.

The surprise rate cut, made via an emergency videoconference last night, responds to a growing sense of crisis in world financial markets, which have been buffeted by problems that began in the U.S. mortgage markets but have now spread well beyond it.

It is the largest single rate cut since 1984, beyond even the initial half-point reduction that the Fed made following the Sept. 11, 2001, terrorist attacks. The new federal funds rate of 3.5 percent will lead to lower rates for credit cards, auto loans and home equity lines of credit. That, in turn, can encourage economic growth by prompting consumers and businesses to spend more.

The tech heavy Nasdaq and the more broadly-based Standard & Poor’s 500-stock index followed the Dow down, each shedding nearly 5percent of their value in early trading, before reclaiming some ground.

Coming more than a week before the Fed’s next scheduled meeting on interest-rate policy, the action reflects the central bank’s judgment of a weakening economy coupled with a financial sector that has “continued to deteriorate.”

The nation’s largest banks and financial companies have been pummeled in recent months by losses linked to risky subprime mortgages. The situation has forced them to write down by tens of billions of dollars the value of a broad array of investments, and also prompted them to become less free to lend to business and even to each other.

The Fed has taken several steps to try to ensure cash continues to flow, including a series of prior interest-rate reductions last fall.

But today’s action was of a different order, reflecting a shift by the Fed into full recession-fighting mode, said Ian Shepherdson, chief U.S. economist with the High Frequency Economics consulting firm.

“The economy is still staring recession in the face, but at least the Fed now gets it,” Shepherdson said.

In a news release accompanying the announcement of the rate cut, the Fed said it had taken the move because “incoming information” showed that a downturn in the U.S. housing market was growing worse, unemployment had begun to rise, and the overall economy was weakening.

On Friday, the Bush administration announced a package of $150 billion in tax benefits designed to encourage spending and help stimulate an economy that appears to be slowing to a crawl – and which in some parts of the country already is displaying signs of recession.

In a speech to the U.S. Chamber of Commerce this morning, Treasury Secretary Henry M. Paulson Jr. called for quick action on that proposal. Following the Federal Reserve action, he said it should serve as a “confidence builder” for investors who have driven global stocks down sharply in recent days.

“Our central bank is nimble and able to respond quickly to market conditions . . . That should be a confidence builder,” Paulson said.

Stocks across Asia registered their second consecutive day of precipitous decline today, and Wall Street was pointed toward a sharply lower opening as fears grew that a weakening U.S. economy could derail growth worldwide.

European markets posted small gains by midafternoon, despite spending much of the day in the red following the sell-off in Asia and negative profit reports from two U.S. banks. Bank of America said that its fourth quarter profit fell 95 percent, to $268 million, compared to the same period a year ago. The decline in earnings, which included a write-down of $5.28 billion in assets tied to risky, subprime home mortgages, missed analysts’ predictions. Wachovia Corp.‘s profit for the quarter fell by 98 percent, to $51 million, compared to the same period in 2006.

As traders digested the news of the last 48 hours, U.S. stock futures at one point indicated an opening drop in excess of 500 points for the Dow Jones industrial average, promising to extend a run of triple-digit losses that has pushed the index down 10 percent since the start of the year.

That began to moderate after the announcement of the Fed move. The global sell-off has involved some of the worst market declines since Sept. 11, 2001, and has erased more than $5 trillion in value from stock markets this year.

Today’s declines in Asia were even more severe than those yesterday, and several markets hit multiyear lows. Indian shares plunged so quickly — nearly 11 percent — that its stock markets halted trading soon after opening. In South Korea, volatile futures prices prompted the main Kospi market to briefly suspend program selling orders at midday. The Australian market suffered its worst one-day fall ever, while Japan’s Nikkei fell 5.65 percent to its lowest point since 2005. It is down nearly 18 percent this year.

In Hong Kong, the Hang Seng index was down 8.65 percent today, after dropping 5.49 percent yesterday. It’s off 19 percent this year and is 30 percent lower than a peak in late October.

“This is an expression of panic — really nothing less than panic about prospects for the U.S. economy,” said Stephen Green, senior economist with Standard Chartered Bank.

For months, some economists had argued that Asian countries remained largely insulated from the problems in the United States because of strong growth in China and India. But recently, companies and financial institutions in those countries have announced that they, too, contain significant exposure to the subprime mortgage securities that have collapsed in the United States.

“People are really scared about the depth and the potential side effects of this recession from the U.S. The data is really bad,” Green said.

“Where the bottom is now is anyone’s guess,” said Wesley Fogel, a market strategist for HSBC.

Officials at the Treasury Department, in the Federal Reserve system and at major stock exchanges worked the phones yesterday — calling one another and their counterparts around the world. A Treasury spokeswoman said only that the department is always monitoring markets and in touch with participants. A spokeswoman for the Fed declined to comment.

The markets fell as fears spread that massive losses on loans made to U.S. home buyers would cascade through the world financial system. Some of the firms that play important, but usually invisible, roles in the global financial architecture are turning out to be exposed to the downturn in the housing market in such a way that their ability to function is threatened.

The companies that insure bond investors against defaults are having to make massive payouts. One, ACA Financial, owes $60 billion that it cannot afford to pay and has been taken over by the Maryland insurance regulator. Its credit rating has been lowered.

The problems among bond insurers have meant that a wide variety of financial institutions cannot count on receiving payments due them, causing further losses.

Other news yesterday shows just how widely the damage has spread. A Chinese newspaper reported that the Bank of China is exposed to subprime U.S. mortgage loans to a degree it had not previously disclosed and may have to write down the value of its $8 billion in such investments. Several large European banks have taken similar hits.

Those losses could have importance beyond the hit they cause to the banks’ share prices. Banks and other financial institutions play an important role in an economic downturn: lending to businesses and consumers so they can help the economy get back on track. The multibillion-dollar losses could make them unable to play that role.

Moreover, foreign investors have been plowing capital into U.S. banks to help them continue lending, which made the losses particularly worrisome, some analysts said.

“Those infusions of capital have been crucial to maintaining performance to date,” said Joseph Mason, a finance professor at Drexel University in Philadelphia. “If foreign investors should significantly retreat from U.S. markets, that leaves us to our own recovery. In that case, the current credit crunch will continue to bite and we maintain a very high risk of recession.”

Many economists have argued that continued growth in the rest of the world — especially in fast-growing markets like China — will help ease the pain of the slowdown in U.S. growth.

With their houses less valuable, U.S. consumers may start spending less, goes this logic, while Asian and European consumers will do just fine, preventing a global economic slump. Yesterday, analysts worried that this theory won’t hold up.

“People are scared, and they are reacting with behaviors which are based on psychology,” said David Kotok, investment chief of Cumberland Advisors. “Some of that can be seen in the stock market, but they are also changing consumer behaviors.”

Many market analysts argued that stock markets in developing countries have appeared to be overvalued for some time, which would suggest that some of the market declines were necessary. For example, even after yesterday’s 5.1 percent drop, the Shanghai composite index in China has risen more than fivefold in the past three years, sparking worries of a bubble.

“Many of the markets, especially the European and Asian markets, have been priced for eternal growth,” said Axel Merk of the Merk Hard Currency Fund.

European officials stressed the underlying strength of their economies, arguing that they can continue to thrive despite weakness in the American economy.

“It seems that the markets are considering the possibility of a more pronounced slowdown, even a recession in the U.S.,” European Union Monetary Affairs Commissioner Joaqu¿n Almunia told reporters yesterday. “I hope they will pay attention also to the real information . . . because, at least in Europe, the economic fundamentals of our economies are sound.”

Most world markets were digesting for the first time the Bush administration’s proposal to try to stimulate the U.S. economy with tax benefits. (It was announced Friday, after Asian and European markets had already closed.)

Traders around the world seemed to have little faith that the plan would arrest the slowdown in the U.S. economy, even if some version of it is passed by Congress.

“Foreign markets are doubtful about the ability of Congress to move quickly, and foreign markets have watched the Federal Reserve move slowly in August, September, October and November,” Kotok said. “So the concern from abroad is that the U.S. has been too slow and done too little and is now playing catch-up.”

White House spokesman Tony Fratto said in a statement yesterday that, while he wouldn’t comment on daily market moves, “We’re confident that the global economy will continue to grow, and that the US economy will return to stronger growth with the economic policies the President called for.”

Congressional leaders yesterday acknowledged how serious the European and Asian sell-offs were and said they may have to rethink the size of the stimulus and its content. Democrats still favor tilting the package toward middle-class and poorer Americans, who would be the quickest to spend any tax refunds or government checks. But Republicans have been pushing for more incentives for investors and business, a possible reaction to the stock-market jitters.

“I don’t want to use the word ‘panicky,’ but you can’t look at the size of these [losses] and not be extremely nervous,” said Rep. Rahm Emanuel (D-Ill.), a former investment banker. Emanuel cautioned that policymakers should not be chasing the markets, trying to reverse losses already in the books.

Toyota and Honda were down more than 5 percent as the sharply rising yen — at a 2 1/2 -year high against the dollar — increased fear of slowing sales in the United States. “There is a sudden sentiment shift to a worst-case, most pessimistic view,” said Naoki Kamiyama, Japan equity strategist at Morgan Stanley. “The market has lost faith in a second-half recovery.”

Cha reported from Shanghai. Staff writers Michael Abramowitz, Jonathan Weisman and Zachary Goldfarb in Washington, Blaine Harden in Tokyo, Molly Moore in Paris, and Kevin Sullivan in London contributed to this report.

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