Fed Cuts Key Rate by Half Point to 1%

Updated from 2:19 p.m. EDT

The Federal Reserve dropped its benchmark interest rate target by 50 basis points to 1% on Wednesday, a widely anticipated move intended to help free up the credit markets.

The Fed funds rate target is now 1%, the lowest level in more than four years. In announcing its decision, the Federal Open Market Committee cited a drop in spending by consumers and businesses, and predicted that consumption may slow further due to tighter lending standards.

"The pace of economic activity appears to have slowed markedly," the FOMC said in a statement, "owing importantly to a decline in consumer expenditures."

Consumer spending accounts for roughly two-thirds of the U.S. economy, and the spread of financial turmoil across the globe "is damping the prospects for U.S. exports" as well, the FOMC noted. All nine Fed governors joined Chairman Ben Bernanke to vote in favor of the rate cut. They also unanimously approved a 50-basis point cut in the discount rate to 1.25%. The Fed funds target affects lending among banks, while the discount rate is what banks pay in exchange for direct loans from the government.

The latest drop in rate targets comes after the central bank and several of its global peers, including the Bank of England and European Central Bank, enacted a 50-basis-point cut on Oct. 8. Since the Fed began a rate-cutting campaign, the funds rate target has dropped 425 basis points, from 5.25% in mid-September of 2007.

The futures market on Wednesday morning had been "priced fully" for a 50-basis point cut with "very low odds" on a 75 basis-point cut, according to Tony Crescenzi, chief bond market strategist at Miller Tabak + Co. Doug Roberts, chief investment strategist at Channel Capital Research, says that while some were predicting a smaller, 25-point cut, "50 basis points was the right number."

Earlier this year, when commodity prices were surging, the Fed had shied away from cutting the rate to keep inflation at bay. However, prices for fuel, food and other products based in dollars have dropped as economic turmoil heated up in early September. Most economists now say the U.S., and perhaps the global economy, is either in a recession or about to enter one. With concerns hinging on a deflationary environment, rather than an inflationary one, the Fed was less concerned about lowering the cost of cash.

Slashing the rates will lower the cost of borrowing for banks almost immediately, which in theory should trickle down to the broader economy. Many types of consumer and business loans are also tied to that rate, though lending standards remain tight. Banks have become extremely averse to risk as more consumers default on mortgages and other types of loans. Many lending institutions now shun nonprime borrowers, require higher down payments and price in added risk with higher rates.

The last time the Fed cut interest rates so sharply was June 2003, when former Chairman Alan Greenspan spearheaded a push for lower rates to boost economic growth following the tech bubble's burst and the shock of the Sept. 11, 2001 terrorist attacks. Before the rate cut, Greenspan had predicted that with inflation and consumption at weak levels, low interest rates could be maintained for "a considerable period." The FOMC gave no indication on Wednesday of how long it may hold its target at the 1% level.

The decision to once again lower the rate target is only the latest in a long string of moves to shore up the financial sector. The central bank on Monday launched a facility to purchase commercial paper, and is now paying interest on bank reserves and accepting a wider range of collateral for loans to banks.

In addition, the Treasury Department has begun its initiative to invest $250 billion in preferred equity stakes in the financial sector, aimed at freeing up lending. The funding comes from the $700 billion Troubled Asset Relief Program, or TARP, approved by Congress earlier this month.

Among banks that have agreed to accept Treasury investments are JPMorgan Chase ( JPM), Bank of America ( BAC), Citigroup ( C), Wells Fargo, Goldman Sachs ( GS), Morgan Stanley ( MS), Bank of New York Mellon ( BK), State Street ( STT), and at least 25 smaller, regional banks. So far, the Treasury has agreed to provide at least 65% of its authorization, or $163.2 billion.

Roberts says that while the cut will affect rates on Treasury notes and certain loans, it was "more symbolic than anything else."

"Really what's going to be more important is thawing out the credit markets," says Roberts, "with the commercial paper funding facility and the TARP legislation. Those go directly to the sources that require credit."

For its part, the Fed predicted that the combination of measures to lower borrowing costs, promote prudent lending an restore liquidity will work in tandem to foster a stronger financial system.

"Recent policy actions ... should help over time to improve credit conditions and promote a return to moderate economic growth," the FOMC said. "Nevertheless, downside risks to growth remain."

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