The Tech - Online EditionMIT's oldest and largest
newspaper & the first
newspaper published
on the web
Boston Weather: 77.0°F | Partly Cloudy

Federal Reserve Cuts Key Short-Term Interest Rate

By John M. Berry
The Washington Post


Worried that a recent sharp drop in the nation's supply of money could be signaling that the U.S. economy will stall again, the Federal Reserve Thursday cut a key short-term interest rate by a quarter of a percentage point, the first such action since December.

After a similar change in the money supply occurred early last summer during the economy's initial rebound from the recession, economic growth all but vanished in the second half of the year.

Federal Reserve officials said they are not sure what has caused the unusual decline in the money supply measure, known as M2, or what it foretells about the economy's strength later this year. But after last year's experience, the officials did not want to take any chances.

"It seems like too big a risk to ignore," a senior Fed official said.

A number of financial analysts said they doubt that the quarter-point drop in the federal funds rate target will be enough to cause major banks to lower the 6.5 percent prime lending rate.

Economists watch the movement of M2 closely because they have found that, at times, it can be a signal of shifts in the economy as a whole, as apparently happened last summer.

The components of M2 tend to reflect and influence the nation's economic activity. The parts include currency in circulation, checking and savings account deposits at financial institutions, certificates of deposit of less than $100,000 and most money market mutual fund shares.

With the unemployment rate at more than 7 percent and inflation running at a subdued pace, Fed officials see little danger that the cut to 3.75 percent from 4 percent in the target for the federal funds rate will spark overly rapid economic growth or inflation down the road. The new target is the lowest in nearly three decades.

Underscoring the point that the economy is hardly about to overheat, the cut in the federal funds rate -- the rate banks charge each other for overnight loans and the anchor for most other short-term interest rates -- came as major retailing chains reported mixed results for March after much stronger gains in the first two months of the year.

By lowering short-term interest rates, the Fed hopes to encourage more money growth in a variety of ways. First, lower rates mean that the public gives up less by way of forgone interest or other return by holding cash. Second, with lower rates, more borrowing may take place its cost in interest payments goes down. As banks lend money, the cash the Fed supplies to the banking system is multiplied several times over and the money supply expands.

The Labor Department, meanwhile, said producer prices for finished goods rose 0.2 percent last month, indicating a modest pace of inflation. Food price declines largely offset a 1.2 percent rise in energy prices. In the past 12 months, prices charged by producers for finished goods, which have a major influence on the prices consumers later pay, have risen just 0.9 percent.

President Bush, speaking to the American Society of Newspaper Editors meeting here, praised the Fed's move. "I am a little more optimistic on the economy and I was very pleased today when the Fed lowered its rates by another quarter," he said. "I hope that this will guarantee that this fledgling recovery that we're seeing will now be a little more robust."

The Fed is worried because in the three weeks ended March 30, the money measure M2 declined by more than $20 billion to $3,461.4 billion. The drop meant that M2 has grown this year at an annual rate of just 2.4 percent.

The Fed has set a target range for M2 growth of 2.5 percent to 6.5 percent. The latest week's decline, figures for which were released Thursday, left M2 not only below the range's midpoint but outside it altogether.

Most investors and financial analysts were surprised by the action, which came before the size of the latest week's M2 decline was known.