NEW YORK - You never want to see the Federal Reserve panic, but that's what it looked like Tuesday when it cut a key interest rate in a surprise move as stock markets around the globe were tanking.
Ben Bernanke's central bank has been late in responding to the current credit crunch, and its latest move amounts to another reactive versus proactive approach. It also stands in stark contrast to the pre-emptive actions favored by former Chairman Alan Greenspan.
As bad as this appears, don't overlook that the Fed's belated medicine may still help an economy that in recent weeks has teetered on the edge of a recession.
The Fed's mandate is to keep the economy growing and inflation under control. But attempting to bail out financial markets — there's really no other way to interpret what it did, taking action a week before a regularly scheduled meeting of the Fed's policy-making committee — also could serve the broader good if it keeps the economy from cratering.
On Tuesday, investors read that as a sign the Fed hit the emergency button, and stocks initially plunged. The Dow Jones industrial average plummeted 465 points in early trading, before giving back some of that decline to finish the day down 128 points. The Dow's nearly 10 percent loss so far in 2008 is its worst start ever for a new year. The same goes for the Standard & Poor's 500 stock index.
The Fed's move reduced the federal funds rate — what banks charge each other on overnight loans — to 3.5 percent from 4.25 percent, marking the biggest funds rate cut since the Fed began explicitly targeting that rate starting in 1990.
The central bank also cut its discount rate, the interest it charges on direct loans it makes to banks, by three-quarters of a percentage point, pushing this rate down to 4 percent. Most banks responded by cutting their prime rates, the benchmark for millions of business and consumer loans to 6.50 percent from 7.25 percent.
Tuesday's reversal is stunning, given how the Fed has been dealing with the financial crisis over the last year. For months, Bernanke and others downplayed the possibility that the collapse in housing would spread to other parts of the economy. Then as rising mortgage defaults caused lenders everywhere to start tightening borrowing standards, the Fed remained largely conservative in its action.
Before Tuesday's move, the Fed had cut interest rates three times, first in September, the month after a severe credit crunch had roiled Wall Street and global financial markets. That half-point rate cut was then followed by smaller quarter-point moves in October and December.
But the Fed's response to date has failed to keep this mess from intensifying and spreading into the broader economy. Falling housing prices have made it harder for homeowners to borrow against their properties, which is affecting consumer spending. That's spooking corporate America, with many companies already protectively holding back on hiring.
On top of that, the Fed has only created more uncertainty among investors and consumers by not looking like it was ahead of the curve in dealing with this mess.
It wasn't until Jan. 10 that the Bernanke publicly opened the door to "substantive" cuts in U.S. interest rates — five months after financial markets had begun to plunge on worries about the economy.
"The Fed has had poor communication, trailed the market, hasn't been grasping the seriousness of the disfunction in the credit markets and repeatedly has been inconsistent in its message," said David Kotok, chairman and chief investment officer at the portfolio management firm Cumberland Advisors. "We still don't know what the consistent policy position is at the Fed."
Some economists hope that Tuesday's move signals a new beginning for Bernanke's Fed. Gone should be the measured approach to mop up the mess left behind by predecessor Greenspan, who kept interest rates at historic lows for so long that it gave rocket scientists on Wall Street free rein to cook up a toxic mix of derivatives and other financial products whose true risk is now apparent.
Greenspan also liked to tout the mantra that the normal operation of market forces would clean up financial excesses. Bernanke has to recognize that today's woes won't improve without the Fed's help.
"Perception is just as important as reality," said Doug Roberts, chief investment strategist at ChannelCapitalResearch.com in Shrewsbury, N.J., noting that the public has to think that the Fed is on the case to fix this mess.
That's why most Wall Street economists see additional rate cuts coming. Some even think the Fed could make a 50 basis point cut in the fed funds rate to 3 percent at its policy-making committee meeting next week.
Lower rates can only be good news for the nation's banks, which have been hit on many fronts of this credit crunch. They're seeing delinquencies rise on all types of loans, and have been badly battered by their investments in mortgage-backed securities and the paralysis in many corners of the credit markets.
At the same time, they've been squeezed by the tighter spreads between their borrowing and lending rates. Banks like to borrow short and lend long — so the drop in the fed funds rate means they can borrow more cheaply and then lend at higher rates.
Assuming the banks don't continue making bad loans, this should boost banks' net interest margin and their profitability, which should shore up their troubled balance sheets. Over time, they then should be comfortable increasing their lending to businesses and consumers.
Looking at Tuesday's action in that light, the Fed's rate cut doesn't look so scary after all.
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