Fed tries to get cash flowing

WASHINGTON - The Federal Reserve took another aggressive step in its campaign to prevent a deep and devastating recession Tuesday, cutting a key interest rate by three quarters of a percentage point. The stock market rallied the most in five years, with the Dow Jones industrial average rising 420 points.

Fed policymakers cut the federal funds rate, at which banks lend to each other, to 2.25 percent. That lower rate should ultimately make it cheaper for Americans to take out adjustable-rate mortgages and borrow money through credit cards or auto loans, and for businesses to borrow money to expand.

The rate cut was the latest measure aimed at halting the intertwined problems of a slowing economy and a crisis in financial markets.

The freeze-up in world credit markets is a major cause of the U.S. economic downturn, and the slowing economy has in turn fueled further problems in those markets. The Fed is trying to halt that vicious cycle with a war on two fronts.

On one front, the central bank has engaged in a redefinition of its role overseeing Wall Street, making emergency loans available to investment banks and taking other unconventional action to try to avert full-scale financial panic. On the other front, dealing with the overall economy, the Fed has undertaken the most aggressive interest-rate cuts in its modern history.

Counting Tuesday's cut, the Fed has slashed the federal funds rate by three percentage points since September.

"We are seeing a remarkably activist Federal Reserve," said Alan Blinder, a Princeton University economist and a former Fed vice chairman. "They are being quite creative in using both traditional weapons and inventing new ones to deal with a pretty unprecedented set of problems."

The efforts to stimulate the overall economy and efforts to thaw the frozen financial markets are related in important ways. The problems in the financial world have made previous Fed rate cuts less effective, keeping mortgage and other consumer interest rates stubbornly high. Thus, if the Fed's elaborate efforts to get the credit markets working again are successful, the interest rate cuts will boost the economy more.

But the central bank gave indications Tuesday not to expect more huge rate cuts. That is partly due to simple math -- with the federal funds rate now at 2.25 percent, there is not much more room to cut, especially at the recent pace. Another restraint is that Fed leaders are worried about inflation, which is being driven by soaring prices for energy and food on world markets.

"Inflation has been elevated, and some indicators of inflation expectations have risen," said a statement from the Fed's policymaking committee, and "uncertainty about the inflation outlook has increased." That is much stronger language about inflation than in other recent communications from the central bank, and it could signal a reluctance to take more big rate cuts unless the economy or financial markets begin to unravel even more than is currently forecast.

Two presidents of regional Fed banks, Richard Fisher of Dallas and Charles Plosser of Philadelphia, dissented from the vote, apparently out of concern that prices are rising too fast, showing that some on the Federal Open Market Committee are already worried that the central bank has cut rates too much.

Fed Chairman Ben Bernanke and his colleagues have said there is almost no home-grown inflation -- the kind driven by a too-tight job market, for example -- in the economy. Rather, they view the price increases as coming from rising prices for food and energy on global commodity markets.

Bernanke has said he expects prices for food and energy to level out this year, as futures markets are forecasting. If that proves correct, it would dampen inflation. But Fed leaders worry that as price increases for those goods filter through to other goods, Americans could get used to prices rising rapidly. Expectations of higher inflation tend to be self-fulfilling.

"The rise in inflation expectations has set a much higher barrier for more rate cuts," said John Silvia, chief economist of Wachovia.

That said, the Fed's statement indicated that "downside risks to growth remain" and that policymakers "will act in a timely manner as needed to promote sustainable economic growth and price stability." Translation: If the economy gets dramatically worse, we'll keep cutting rates.

The Fed has in the past two weeks intervened in the financial markets in dramatic fashion, using a whole range of tools to try to push financial institutions to have enough confidence in one another to keep the flow of credit running through the economy. It amounts to a wholesale rewriting of its role managing the financial system and has happened suddenly, with no real political debate.