On January 22nd, 2008 the Federal Reserve took drastic step in an effort to prevent widespread stock market losses across the globe: it cut interest rates by three-quarters of a percent. This compares to the half point cut that was made after the September 11th terrorist attacks. By issuing the percentage cut, which was the largest in 24 years, the Federal Reserve was able to accomplish its objective. The Dow Jones industrial average decreased by 1. 1 percent, which was far less dramatic than the 7 percent decrease Asian and European markets experienced earlier in the week.
In addition to mitigating a potential sharp decline in the Dow Jones index, the European and Asian markets moderated after the rate cut was announced. Investors in futures markets also predict that the Federal Reserve will cut rates once again at its upcoming regularly scheduled meeting. One effect of the rate cut is lower cost for both consumers, who borrow money through credit cards and home equity loans, and for businesses which take out loans to expand.
The rate cut should also lead to lower rates on adjustable-rate mortgages while long term, fixed rate home loans are likely to remain unaffected. Lower rates also cause weakness in the dollar, which should help U. S. exporters, as well as possibly help banks become more profitable and rebuild their capital, thereby gaining more solid footing. While foreign markets moderated after the rate cut announcement, debt markets, which are the source of the economic slowdown, remain unchanged.
There is also concern that the efforts such as tax cuts by President Bush and Congress, will also do little to stimulate the debt markets. According to Mark Zandy, lead economist of Moody’s Economist. com, tax cuts and lower rates will only give policymakers more time to address the problem; however, they will not actually solve it. In light of a possible looming recession, the Fed decided to take action before its upcoming meeting due to fears of greater dangers that could result from delayed action.
With credit becoming harder to obtain, housing contraction worsening, and a worsening labor market, the early rate cut was intended to avoid a cycle of worldwide losses. The leaders from central bank have indicated that they are inclined to continue cutting rates as they deem necessary in the coming quarters. Although Fed leaders justified the rate cut by applying conventional economic principle, the crisis in global financial markets is what prompted the Fed to react. According to Chairman Ben Bernanke, a decline in the stock market alone is not sufficient reason to cut interest rates.
In this case, the decline in the stock market was viewed as a sign of declining confidence in the financial system, which is a legitimate reason for the Fed to take action. While rate and tax cuts may boost confidence among companies and consumers, the debt markets remain unaffected. Containing the credit crunch is a struggle because many financial firms have invested in the housing market, and foreclosures are currently at record levels, thereby generating losses in many firms. This recession is more dangerous than others because it affects consumer and business spending.
The Fed is particularly concerned with bond insurers who typically help municipalities and companies with weak credit borrow money. Bond insurers now must cover more losses than they can afford and some may be at risk of failing. New York insurance regulators are looking for ways to infuse new capital into the bond market for municipal bond insurance. As part of this effort, the New York State Insurance Department has convinced Warren Buffet’s company to enter the market for municipal bond insurance.