Fed Cuts Rates Again

Recording artists Snopp Dogg and P. Diddy perform on stage at the Hartwall Areena, on March 9, 2007 in Helsinki, Finland. This concert marks the beginning of the European Tour. (Photo by Dave Hogan/Getty Images)
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The Federal Reserve cut interest rates again Thursday, a second rate cut in as many days aimed at keeping the American economy growing.

The Fed cut the discount rate, the rate for loans the Fed makes to banks, a quarter-point to 5.5 percent. In a statement explaining its move, the Fed said it was cutting the discount rate because of requests from twelve Federal Reserve banks.

Since banks rarely borrow from the Fed, the cut was seen as largely symbolic, meant to underline the Fed's concern about the slowing economy.

The cut came a day after the Fed had cut both the discount rate and the federal funds rate on overnight bank loans to other banks, moves that sent stocks soaring. The Fed said Wednesday it stood ready to cut the discount rate more on the request of Federal Reserve banks.

The Fed's Thursday rate cut was announced after markets closed on a day in which the major U.S. stock indexes took a step back. The Dow Jones industrial average closed down 40.15 points to 10,905.60, according to early and unofficial closing numbers from CBS MarketWatch. The Nasdaq slipped 49.40 to end the session at 2,567.29, while the Standard & Poor's 500 Index lost 14.32 points to close at 1,333.24.

Some analysts said the fact that the markets backtracked only slightly means investors are showing some willingness to be patient with the economy.

"We're not giving back all of the gains we made yesterday. or even half of the gains we made yesterday," said Hugh Johnson of First Albany. "That's a good sign."

CBS News Correspondent Anthony Mason reports the Fed usually only changes rates at its regular meetings. The last time the Fed changed rates between meetings was a quarter-point cut in October 1998, when the central bank was moving aggressively to counter worldwide financial turmoil caused by the Asian currency crisis.

This time around, the Fed said the spreading slowdown sparked the sudden move. There was more evidence of ebbing growth in three economic reports released Thursday.

How does the Fed change interest rates?
The Federal Reserve can raise or lower interest rates in three ways:

1) Open market operations.
This is a fancy way of saying selling or buying government bonds. If the fed wants to raise rates, it sells governmnt bonds to banks. Banks pay for the bonds in cash. That means banks have less money to lend out, so interest rates rise.

In the reverse, the Fed buys bonds to lower rates. It pays banks cash for the bonds, and the banks have more money to lend, so rates drop.

2) The federal funds rate or the discount rate.
The federal funds rate is what the Fed charges banks for borrowing money from the Fed to meet reserve requirements. The discount rate is what banks charge each other to borrow money to meet reserve requirements.

By hiking these rates, the Fed discourages borrowing, and banks have less money to lend, so interests rates go up. By lowering either rate, bank borrowing is likely to increase, and loans to customers will increase as well, dropping interest rates.

3) Reserve Requirements.
Banks are required to keep on hand a certain amount of cash based on their total deposits. If the Fed raises or lowers the required amount, it affects how much the banks can lend out to customers.

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The nation's retailers reported disappointing holiday sales. Orders to U.S. factories bounced back a bit in November, rising 1.7 percent as demand grew for airplanes, electronics and industrial machinery. However, the rise was not enough to recover the 4.0 percent decline in orders in October.

In another report, the Labor Department said new claims for state unemployment insurance rose last week by 16,000 to a seasonally adjusted 375,000, the highest point in more than two years and suggesting that employers' demand for workers is waning.

It marked a larger increase than some analysts were expecting and the highest level since July 4, 1998, when claims were at 384,000.

The new numbers fueled concerns the once red-hot economy is cooling off.

The economy slowed dramatically in the third quarter of 2000, growing at an annual rate of 2.2 percent, the weakest pace in four years. That compared with a sizzling 5.6 percent rate in the second quarter.

More recently, consumer confidence has fallen sharply and retail sales have been lackluster. The index of manufacturing activity fell last month to its lowest level in nine years.

It was less than a month ago — at its last meeting of 2000 — that the central bank switched its policy statement from one leaning toward inflation concerns to one emphasizing recession risks. Between June 1999 and May of 2000, the Fed boosted interest rates six times in an effort to slow the economy and keep inflation under control.

After that announcement, stocks on Wall Street slumped, reflecting disappointment by investors that the Fed had not cut rates at that meeting.

The Federal Open Market Committee, which includes Fed Chairman Alan Greenspan, Fed governors and five of the 12 presidents of Fedral Reserve banks, is scheduled to meet Jan. 30-31 to review interest rates. Some analysts feel another cut could come then.

The Fed tries to steer the economy away from either inflation — in which prices swell, making business decisions more difficult and reducing consumers' buying power — or recession, when the economy contracts, costing jobs.

The Fed raises interest rates to prevent inflation, since higher rates make it more expensive to borrow money and slow spending, reducing pressure on prices to rise.

The Fed cuts rates to make it easier to borrow money to spend or invest, stimulating the economy to encourage economic growth and avoid recession.

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