Washington — The Federal Reserve cut a key interest rate by a half a percentage point Friday, moving to ease a credit crunch and calm global financial markets by making it cheaper for cash-starved institutions to borrow directly from the central bank.
The Fed also said in a statement that recent turbulence in financial markets had significantly increased the risk that the economy would worsen. Investors interpreted the two moves, taken together, as a signal that the central bank is prepared to take serious action to try to prevent disruptions that began in the market for mortgages from spreading widely through the economy.
Investors welcomed the news by sending stocks up for the day: The Dow Jones Industrial Average closed up 233.30 points, as investors reacted to news that the Fed had reduced the rate at its "discount window" to 5.75 percent from 6.25 percent.
The Fed's action Friday morning signaled a shift from its public statement issued 10 days ago, when the Fed's policy-making arm identified inflation spurred by an overheated economy as the biggest risk in the near future. But since then, the market for many mortgages and corporate debt have come to a near standstill, investors have dramatically bid up the price of safe assets, and stock values have fallen sharply in the U.S. and around the world.
The potential for an economic downturn appears to have supplanted inflation as the Fed's greatest immediate worry.
"The committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets," the policy-making committee said in its statement Friday morning.
But while the committee indicated that the risks of an economic downturn had risen, the Fed shifted an interest rate that has little direct impact on the economy.
"They still believe this is a short term liquidity squeeze, not a fundamental change to the economic picture," said John Silvia, chief economist of Wachovia Corp.
There are two basic problems going on in the markets. Many investors are so fearful of further losses that they are unwilling to buy risky mortgages and corporate debt at any price, so financial institutions cannot find buyers even for relatively safe packages of mortgages and other debt. And market participants of all stripes are moving money from risky assets into cash, leading to a shortage of money in the economy.
The Fed action attempts to deal with both problems. Banks can use their portfolios of mortgage-backed securities as collateral to borrow money from the Fed - no questions asked - at the now-reduced rate.
Notably, the Fed did not lower the federal funds rate, which affects the borrowing costs for consumers and businesses and thus has a direct impact on the economy.
Currently set at 5.25 percent, the federal funds rate is used for loans between banks, and influences a range of consumer borrowing, including some mortgages, credit cards and student loans.
The shift in the discount rate only will affect the broader economy inasmuch as it calms the financial markets.
"The message to the markets is, to the degree some of this activity in the market is irrational, we will prevent the financial markets from harming themselves through their own irrationality," said Neal Soss, chief economist of investment bank Credit Suisse.