Fed Cuts Interest Rates Again

WASHINGTON -- Federal Reserve policymakers cut short-term interest rates a quarter-point to a 45-year low of 1% Wednesday and signaled they are ready to cut still further to head off deflation and ensure a return of robust growth.

The drop in the signal-sending federal funds rate -- the interest banks charge one another for overnight loans -- was less than the half-point cut many had expected. It suggested the Fed is not quite as concerned about deflation, or a generalized price decline, as it indicated last month.

But the cut reflected how nervous policymakers are about the economy’s fragile condition, and suggested that the central bank is ready to go to even more extraordinary lengths than it has already gone to rekindle strong growth.

The latest cut was the 13th since the Fed began feverishly slashing rates in early 2001, and brought the funds rate to its lowest level since July 1958, when Dwight Eisenhower was president.

San Francisco Federal Reserve Bank President Robert T. Parry took the unusual step of breaking with colleagues on the policymaking Federal Open Market Committee, saying he thought the panel should have cut a full half-point.

Parry, long a staunch inflation fighter, said as early as last year that he thought deflation now posed the greater danger to the U.S. economy. He traced his change of heart to the experience of Japan, which after growing rapidly through the 1980s slipped into a deflationary downturn from which it has yet to emerge.

In a statement accompanying their 11-1 decision, policymakers said that while recent economic data showed “a firming in spending, markedly improved financial conditions and labor and product markets that are stabilizing,” the economy “has yet to exhibit sustainable growth.”

The central bankers added that the danger of an “unwelcome substantial fall in inflation,” though minor, outweighed chances of a pickup in prices -- a comment analysts said signaled the Fed intends to keep rates low for the foreseeable future.

“I don’t think [Fed Chairman Alan] Greenspan is all that worried about deflation, but he wants to make sure it doesn’t happen,” said Carnegie Mellon University economist Allan Meltzer.

If the Fed believed there was a big risk of deflation, it would be likely to cut rates sharply in hopes of causing a burst of economic activity that would send up prices, reversing their downward trend. Fed officials and others worry about deflation because, once underway, it creates incentives for businesses and consumers to put off purchases in hopes of getting lower prices, causing the economy to run at a slower and slower pace.

The big question now is how much of a difference, if any, the Fed’s quarter-point rate cut will make to the economy.

Stock and bond investors were not impressed. The Dow Jones industrial average fell 98.32 points, or almost 1.1%, to close at 9,011.53. The broader Standard & Poor’s 500 index slipped 8.13, or 0.8%, to 975.32.

Longer-term interest rates staged a sharp reversal with the 10-year U.S. Treasury note’s yield, or market rate, climbing to 3.40% from 3.25%. Such a rise in long-term rates is just what the Fed did not want to see.

New statistics out Wednesday suggest those parts of the economy that are buoyed by low rates -- especially housing -- are already doing so well that it’s hard to imagine them doing much better even with the latest cut.

Fueled by falling mortgage rates, new-home sales unexpectedly jumped 12.5% last month to a record 1.157-million-house annual pace, the Commerce Department reported. Sales of existing homes also climbed, although a less dramatic 1.2%, to a 5.92-million annual rate, according to the National Assn. of Realtors.

Commercial banks typically follow the Fed’s lead by cutting or raising their interest rates. But no major bank lowered its prime lending rate Wednesday in response to the Fed action. The prime is 4.25% at most banks.

Southern California banks followed their traditional policy of waiting for larger banks to make the first move down.

Like other California banks, East West Bank in San Marino will wait to cut its rate until it sees a move “by the big players on Wall Street and the money center banks,” said East West Chief Financial Officer Julia S. Gouw. “There has been some talk that the major banks may not do it,” she said, “because the rate is just so incredibly low.”

The chairman of the California Bankers Assn., Curtis S. Reis, said the Fed’s “very tepid rate cut” had sent a signal to homeowners that the bottom in interest rates almost surely had been reached. “This should send a message to a lot of people -- if you haven’t refinanced yet, do it now,” Reis said.

While housing has greatly benefited from lower rates, those parts of the economy on which policymakers are now relying for a strong rebound have been unmoved by low rates to date and seem unlikely to be jolted back to life by the latest cut.

Indeed, there were fresh signs of weakness Wednesday in the long-suffering manufacturing sector. The Commerce Department said durable goods orders unexpectedly fell 0.3% in May.

Analysts said the decline is a sign that corporate America has yet to resume full-scale investment in new plants and equipment, and also will further discourage businesses from making new investments. Neither problem will be solved by lower interest rates, experts said.

“Lower rates are not going to do much for business capital investment,” said Wachovia Corp. chief economist John E. Silvia. “What companies need to see is stronger final sales and opportunities to make money before they start investing again,” he said.

At this point, the consensus among economists is that the combination of drastically low interest rates, the third tax cut in three years and a decline in the value of the dollar, which makes U.S. exports cheaper and therefore more appealing, should kick the economy out of its doldrums.

But analysts readily concede that the economy’s failure to respond to the inducements to recovery that Washington has lavished on it gives them pause. “If this doesn’t work,” quipped Bank One chief economist Diane Swonk, “you can throw the book out on economics.”

Despite repeated assertions that it’s now on the mend, the economy has lost 324,000 jobs so far this year and grew at an anemic 1.9% pace during the first three months of the year.

The Fed also cut on Wednesday its largely ceremonial discount rate -- the interest the Fed itself charges on overnight loans -- by a quarter-point to 2%.

Times staff writer E. Scott Reckard in Orange County contributed to this report.