Economy & Trade, Headlines, North America

FINANCE: U.S. Rate Cut Reflects Economic Woes

Abid Aslam

WASHINGTON, Sep 19 2007 (IPS) - When the U.S. central bank cut interest rates Tuesday, it signaled that the world’s largest economy is in worse shape than it was willing to admit just last month.

The Federal Reserve’s policy-making committee cited the risk of an economic downturn triggered by a collapsing housing market in announcing it was lowering its benchmark interest rate. It cut the Fed funds rate, which banks charge each other for overnight loans, by half a percentage point to 4.75 percent, the first rate cut in four years.

“Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction, and to restrain economic growth more generally,” the Federal Open Market Committee (FOMC) said in a statement.

“Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets,” it said, adding that the central bank would “act as needed to foster price stability and sustainable economic growth.”

Further rate cuts seem likely: Market players said they expect the funds rate to fall by another half-point before the end of the year. The rate had stayed at 5.25 percent since 2006.

As recently as Aug. 7, when it last met, the FOMC said inflation was the “predominant” threat. Two days later it acknowledged “downside risks” to the U.S. economy and on Tuesday it exceeded many economists’ expectations and trimmed the rate by half a percentage point rather than by one-quarter of a point, as many had thought likely.

Since then, however, official data have suggested that trouble is spreading through the economy. Job growth has been slowing for several months and in August, employers cut 4,000 jobs – the first such hiring contraction in four years and a surprise: Economists had expected the addition of 100,000 jobs. This is the number of new jobs the U.S. economy must generate every month just to keep up with the growing working-age population. Additionally, retail sales have fallen below economists’ expectations.

The Fed also lowered Tuesday the discount rate, which it charges when lending directly to banks, by half a percentage point to 5.25 percent. This was the second such cut in a month.

The moves were intended to stabilise financial markets and to buoy investor confidence despite the other consequence normally associated with lower interest: inflation. To avert a cash crunch, the funds rate cut would make it cheaper for banks to loan to each other and the discount rate reduction would make it cheaper for them to borrow from the Fed.

Wall Street had clamoured for rate cuts and initial market reaction to the Fed’s moves was upbeat: Stocks, energy, and precious metals all rocketed on the announcement. Whether the investment outlook improves significantly in coming weeks and months, and whether the economy is lifted as a result, remains to be seen.

Also uncertain are the political ramifications. Presidential and congressional elections are due late next year and, by some estimates, as many as one million U.S. homes face possible foreclosure by then.

Nancy Pelosi, the top Democrat in the U.S. House of Representatives, summed up the political stakes Tuesday, saying in a statement that the Fed move “underscores the economic insecurity that middle-class Americans have long been feeling.”

Industry experts have warned that one million or more U.S. homeowners face foreclosure in the next year or two. Some 550,000 U.S. borrowers lost their homes in the past year, according to the national Mortgage Bankers Association. In large measure, this was because borrowers could not keep up with mortgage payments as initially low but variable interest rates were reset at higher levels. At the same time, home prices have stalled or begun to slip, eroding what for most homeowners is their chief asset and their largest source of debt.

Of particular concern are subprime mortgages, made to borrowers with modest incomes, weak credit, or both. Lenders say the loans are designed to mitigate their risk of loss so they can extend credit to chancy customers. Their critics counter that subprime loans are predatory: That lenders deliberately impose terms that borrowers could never meet, all but guaranteeing default and foreclosure.

So long as borrowers could keep up with their mortgage payments, the loans performed well and institutional investors sunk vast sums in securities backed by the dodgy mortgages. As defaults climbed, however, companies found it hard to obtain credit and investors fled. The market for these mortgage-backed securities shriveled.

At least 15 U.S. lenders have filed for bankruptcy and a number of major finance firms have announced cutbacks in or the closure of units dedicated to subprime-related investing. Banks as far away as China have acknowledged exposure to the crisis because either they bought the asset-backed securities or they invested in other financial institutions that in turn held the high-risk, potentially high-return commercial paper.

Turbulence likely will continue to test world financial markets and could dampen global growth but overall expansion should continue regardless, top officials at the International Monetary Fund (IMF) have said.

“While the strains in global financial markets have not played out fully, some moderation in global growth is to be expected in the coming year,” John Lipsky, number two at the IMF, said in a prepared speech Monday at a conference here of the Association of American Chambers of Commerce in Latin America.

“The still ongoing turbulence in financial markets represents a significant test, but one that should not undermine the global economy’s positive momentum,” Lipsky added.