The Federal Reserve, the U.S. central bank, has decided to cut interest rates again. Here's a look at why the decision was taken and what effect it will have.
Q: Why has the Federal Reserve cut rates again?
The federal reserve cuts interest rates to help boost the economy. The latest cut a half a percentage point came Tuesday, and markets slid on the news. At left, a trader works on the floor of the New York Stock Exchange minutes before the closing bell.
A: The Fed decided to act to reassure markets, businesses, and consumers about the economy.
After eight years of strong economic growth, the U.S. economy began a sharp slowdown during the last few months of 2000, which has been reflected in a sell-off in the stock market.
Most evidence suggests that the slowdown has continued, and that consumer and business confidence remains fragile, despite the reduction of U.S. interest rates by 1 percent in January. The hope is that lower interest rates will encourage businesses and consumers to spend more, and reduce the burden of debt.
Q: What difference will it make to the markets?
A: U.S. stock markets have gone into a tailspin this year, with major indices down some 20 percent since January.
The Nasdaq, the high-technology index, has fallen by more than 60 percent since its peak one year ago. Most European markets also are sharply down.
Investors fear the U.S. recession will reduce company profits, and that shares have been too expensive.
An interest rate cut could help in two ways.
First, if it helps the economy to recover, it should help profits recover in the long term.
In the short-term, however, a fall in interest rates also makes shares more attractive as an investment compared with bonds, the other main financial investment. Bonds pay a fixed rate of interest, so with lower interest rates they become more expensive.
But markets have a momentum of their own, and after the severe tumble they have taken in the past few months even a big rate cut might not be enough to restore optimism. After all, markets continued to fall despite the 1 percent rate cut in January.
Q: What do such reduced interest rates mean for households?
A: In general, an interest rate cut makes it cheaper to borrow money such as mortgages but also reduces the income savers receive.
U.S. households borrowed heavily during the economic boom, using their rising share prices as collateral.
Because there are many Americans invested in stock markets, the wealth of more people is directly linked to the rise and fall in share prices.
Q: Does this mean more rate cuts ahead?
A: While most experts predict that the cost of borrowing will come down again, there may be a limit to how far the Fed will want to cut interest rates while there is still some life in the economy.
Even during the Asian financial crisis, the Fed only cut interest rates three times in an attempt to stabilize the global financial system.
And although stock markets have fallen sharply, it remains unclear how deep and long-lasting the overall economic slowdown will be.
Unlike during some other crises, other financial markets such as the bond market, where companies borrow to finance their expansion are holding up well.
The Fed also may want to wait to see how the economy responds to its earlier moves.
Q: How quickly do interest rates work?
A: Because households and businesses only adjust their spending plans infrequently, a rate cut will not necessarily have an immediate effect on the economy.
Most economists believe it could take from six to nine months before an interest rate cut changes spending patterns.
The Bush administration also wants Congress to cut tax rates to help stimulate the economy. However, it may be the end of the year before the legislation becomes law and people might not see the benefit in their tax returns until April 2002.
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