Kamp's Comments - Worries About the Economy Prompt Another Rate Cut by the Fed

by Leo Kamp, Managing Director and Chief Investment Economist, TIAA-CREF

As investors expected, the Federal Reserve lowered interest rates again this afternoon. This follows rate cuts totaling three-quarters of a percentage point in September and October. Today the Fed lowered their federal funds target by another quarter of a percentage point. That rate — the one banks charge one another for overnight loans — is now a full percentage point below the 5.25% rate that prevailed during most of 2007. In addition, the Fed also lowered its discount rate — the rate it charges financial institutions for borrowing directly from the Fed— by one-quarter of a percentage point to encourage financial institutions to borrow from the Fed to increase their liquidity positions.

Why did the Fed cut rates again, after signaling a reluctance to do so following their last meeting, in late October? Basically because the turbulence in the financial markets arising from the sub-prime mortgage debacle has not abated to the extent the Fed had hoped. A number of major financial institutions continue to write off large amounts of distressed sub-prime mortgage-related debt. In some cases, these write-offs reduced the capital positions of the institutions to such an extent that capital injections were sought from external sources (e.g., the capital commitment Citigroup received from an Abu Dhabi investor). As a result, the Fed is probably now more worried about a generalized tightening of credit conditions and its possible toll on the economy. After all, much of the recent growth in the United States has been fueled by borrowing, especially by households.

While economic momentum remained robust in the third quarter (a recent report showed real GDP grew at an annual rate of 4.9%), there are increasing signs that fourth quarter growth will be just 0–1% (at an annual rate) as a result of lackluster retail spending, anemic investment growth, and ongoing distress in the housing market. Consequently, Fed Board members have recently become increasingly concerned about the economy’s slowing severely, or even falling into recession, in 2008.

Surprising, given the risks to the economy, the Fed had no "balance of risks" statement in its press release this time, although they did mention the still-present risks of higher inflation and increased uncertainty about economic growth. This is in contrast to their October statement, which stated that the risks of inflation's moving higher and the economy’s faltering were in "rough balance." The Fed did, however, reiterate its willingness to lower rates further if the data suggest the economy is weakening too much.