Friday, August 17, 2007


Aug. 17 (Bloomberg) -- The Federal Reserve lowered the interest rate it makes to banks and acknowledged for the first time today that an extraordinary policy shift is needed to contain the subprime-mortgage collapse that began roiling the world's financial markets two months ago.

The Fed, in a surprise announcement in Washington, lowered the so-called discount rate by 0.5 percentage point, to 5.75 percent. Policy makers dropped language indicating their bias toward fighting inflation, and instead highlighted a rising threat to economic growth.

``This telegraphs their intention to cut rates at the next meeting,'' said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. ``This discount rate cut calms the market and helps financing.''

This is the first reduction in borrowing costs between scheduled meetings since 2001, and Ben S. Bernanke's first as Fed chairman. Officials kept the benchmark federal funds rate target for overnight loans between banks at 5.25 percent. Policy makers next meet to set the rate on Sept. 18. Futures indicate traders anticipate at least a quarter percentage point cut.

The Fed said while recent reports indicate economic growth continues at a ``moderate pace,'' risks to the expansion have risen ``appreciably.'' The statement is a marked change from just 10 days ago, when officials kept rates unchanged and reiterated that inflation was their ``predominant'' concern.

`Restrain' Growth

``Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth,'' the Federal Open Market Committee said today. ``The committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects.''

Stocks rose. The Standard & Poor's 500 index gained 0.8 percent to 1,422.35 as of 10:50 a.m. in New York.

FOMC members convened in a conference call at 6 p.m. Washington time yesterday, Fed spokeswoman Michelle Smith said. The Fed's Board of Governors then accepted requests by the New York and San Francisco banks to cut the discount rate.

Today's action also includes an extension in so-called discount window borrowing, allowing 30-day financing that's renewable, instead of a standard overnight loan. The Fed's board sets the discount rate while the FOMC, which includes the governors and heads of five of the 12 district banks, determines the federal funds target rate.

Cash Injections

The Fed loosened terms on discount-window borrowing after its injections of cash into the federal-funds market in the past week failed to ease companies' access to capital. The amount of commercial paper outstanding, a key financing tool, had fallen the most since the 2001 terror attacks.

Lowering the discount rate ``will basically do more to unclog the credit channels than a fed funds rate cut would have,'' said Drew Matus, senior economist at Lehman Brothers Holdings Inc. in New York, who used to work at the Fed. ``It was exactly the right thing to do.''

The central bank will ``continue to accept a broad range of collateral,'' including home mortgages and ``related assets,'' it said.

Fed policy makers next meet on Sept. 18, when economists said they are likely to reduce the benchmark rate by at least a quarter percentage point from 5.25 percent. Officials have kept the rate unchanged since last raising it in June 2006.

Housing Recession

The Fed's action reflects alarm that more restrictive lending conditions and volatility in financial markets will deepen the housing recession, weaken employment and erode economic growth. As recently as the Aug. 7 meeting, the FOMC said inflation was still the biggest danger to the economy.

The Fed noted then that ``financial markets have been volatile,'' though the economy was still expected to continue to expand at a ``moderate'' pace. Today's FOMC statement, approved unanimously by 10 Fed governors and presidents, didn't mention inflation.

Figures released by the Fed yesterday showed that discount lending failed to rise much over the past week after the central bank issued a statement on Aug. 10 saying that ``as always, the discount window is available as a source of funding.'' Total loans outstanding totaled $264 million on Aug. 15, compared with $255 million on Aug. 8.

Today's decision shows policy makers understand ``the various different tools the central bank has at its disposal,'' said Neal Soss, chief economist at Credit Suisse in New York, who worked as an assistant to former Fed Chairman Paul Volcker. ``This is a masterful move because it doesn't actually feed some of the concerns about moral hazard'' of bailing out investors, he said.

Biggest Challenge

The subprime rout is the biggest challenge for Bernanke, 53, since he took office in February 2006. Under predecessor Alan Greenspan, the Fed in 1998 cut interest rates three times as currency crises in emerging markets roiled Wall Street.

In the past week, the Fed and central banks in Europe, Japan, Canada and Australia have been compelled to add money to the banking system. The collapse in demand for securities backed by subprime mortgages has forced at least 90 lenders out of business.

The European Central Bank began adding liquidity on Aug. 9 after BNP Paribas SA, France's biggest bank, was forced to halt withdrawals from three of its investment funds. The Fed followed, along with counterparts from Sydney to Oslo.

Mortgage defaults by Americans with poor credit histories prompted the collapse in June of two hedge funds managed by Bear Stearns Cos. and triggered a worldwide rout in the debt markets. Companies such as London-based Cadbury Schweppes Plc have delayed asset sales, and banks including JPMorgan Chase & Co. and Deutsche Bank AG have been left on the hook for as much as $300 billion of debt they've agreed to provide.

Yesterday, Countrywide Financial Corp., the biggest U.S. mortgage lender, had to tap an entire $11.5 billion bank line to obtain funds.

Economists and policy makers anticipate a slower expansion in the second half. For the year, Fed governors and presidents expect growth, on average, of about 2.25 percent to 2.5 percent, Bernanke told Congress last month. The projections are about a quarter-point below the last round in February, mainly on weakness in homebuilding.

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