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How Much Will Bernanke Cut?

Bernanke

JEANNINE AVERSA   01/30/08 05:33 PM ET   AP

WASHINGTON — The Federal Reserve delivered powerful new relief to people and businesses squeezed by the ailing economy Wednesday, cutting interest rates ever deeper in an effort to avert or at least soften the blow of a recession.

The bold, half-point reduction approved by Fed Chairman Ben Bernanke and all but one of his colleagues came as President Bush and Congress raced to enact a separate rescue package _ including tax rebates for individuals and tax breaks for companies _ to help energize an economy in danger of stalling.

Heartened by the Fed's newfound aggressiveness, Wall Street rallied but then pulled back, still wary. The Dow Jones industrials jumped more than 200 points after the announcement but ended up down 37.47.

Commercial banks followed the Fed action by lowering their prime lending rate by the same half percentage point _ to 6 percent, the lowest in nearly three years. That prime rate applies to certain credit cards, home equity lines of credit and other loans.

Hours before the Fed's action, the government reported that the nation's economic growth had stumbled to a virtual halt. The economy grew at just a 0.6 percent pace from October through December, and for all of 2007 it logged its weakest performance in five years.

The collapse of the housing market, sour mortgage investments and much harder-to-get credit are weighing on people and businesses alike. Foreclosures have hit record highs, and banks have racked up multibillion-dollar losses. The fallout has shaken Wall Street, catapulted the economy to Topic A among worried families and galvanized political figures, including those vying to be the next president.

"The economy is hanging by a thread," said Stuart Hoffman, chief economist at PNC Financial Services Group.

While Wednesday's interest rate cut was welcome, the Fed's blunt new assessment of the economy was sobering for everyone from business owners to people worried about debts to anyone without a job _ or fearful of losing one.

"Credit has tightened further for some businesses and households," the Fed said. "Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets."

In its 9-1 decision, the Federal Reserve dropped its key rate to 3 percent at the end of a two-day meeting. Richard Fisher, president of the Federal Reserve Bank of Dallas was the sole dissenter. He preferred no change.

It was the second Fed rate cut in just over a week, and the policymakers signaled they were prepared to keep going lower if needed.

There had been a rare, three-quarter point reduction last Tuesday. Bernanke had convened an emergency session after stocks worldwide plummeted, intensifying recession fears. The cuts have helped to restore some confidence among skittish investors, but financial markets remain fragile.

In the gravest challenge to his leadership since becoming Fed chief nearly two years ago, Bernanke must help stem the fallout from both the housing bust and a credit crunch. Wall Street critics and others have taken Bernanke to task for waiting until September of last year to embark on a rate-cutting campaign, accusing the Fed chief of being behind the curve in dealing with the economy's problems.

Bernanke also must be mindful of not letting inflation get out of hand _ a delicate and tricky maneuver. Oil prices have receded from $100 a barrel but still remain high. The Fed said it expects inflation to ease in coming quarters but added that it is imperative to monitor developments carefully.

Still, more rate cuts are expected at the Fed's next scheduled meeting in March and beyond. Some economists predict the key rate could drop as low as 2 percent this year, which would be the lowest in four years.

"The Fed needs to throw out a life raft to the economy pending the fiscal stimulus measures," said Brian Bethune, economist at Global Insight.

Even further action might not avert a recession but rather limit the damage. The interest rate cuts will take months to affect the economy, as will any stimulus package approved by the government. Neither effort will quickly cure the root cause of the economy's troubles: a severely depressed housing market and bad mortgage investments.

The economy may actually be declining now. Under one rough rule, it would have to contract for six months in a row for the country to be considered in a recession. The likelihood of a recession has risen sharply over the past year, and analysts increasingly believe the U.S. will be in one during the first half of 2008. The worry is that people and businesses _ which turned more cautious at the end of the year _ will hunker down, sending the economy into a tailspin.

Bernanke is not expected to cut rates as deeply as did his predecessor, Alan Greenspan, when Greenspan took on the 2001 recession, the economic fallout of the Sept. 11 attacks, a series of accounting scandals that rocked Wall Street and the uncertainty that gripped the country leading up to the U.S.-led invasion of Iraq in March 2003.

By the summer of 2003, Greenspan had slashed rates to 1 percent, a 45-year low. He held rates there for a year before the Fed began pushing them back up.

Critics contend those low rates helped feed a housing frenzy, in which home values zoomed and investors gobbled up risky loans, known as subprime mortgages, to borrowers with poor credit histories. When the housing market collapsed, the greatest damage was in subprime loans. Banks and other financial institutions have taken big hits on these soured mortgage investments.

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On the Net:

Federal Reserve: http://www.federalreserve.gov/

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Filed by Michelle Kung  |