Fed slashes key rate to 3.5%

NEW YORK (CNNMoney.com) -- The Federal Reserve slashed two key interest rates by three-quarters of a percentage point Tuesday following an unscheduled meeting, citing continued concerns about a weakening economy and turmoil in the financial markets.

The Fed lowered its federal funds rate, which impacts how much consumers pay on credit card debt, home equity lines of credit and auto loans, to 3.5 percent from 4.25 percent.

The rate cut came more than a week before the Fed's next regularly scheduled meeting, a two day session that concludes on Jan. 30. Some market observers think the Fed will cut rates again at this meeting.

The Fed also lowered its discount rate, which is what it costs banks to borrow directly from the central bank, by three-quarters of a point, to 4 percent.

This was the biggest rate cut by the Fed since October 1984. And it was the first cut between regularly scheduled meetings since a half-point cut on the day the market reopened following the September 2001 terrorist attacks

"Broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets," the Fed said in a statement.

Treasury Secretary Henry Paulson, speaking at the U.S. Chamber of Commerce in Washington Tuesday morning, said that he hoped the rate cut would restore some confidence in the financial markets and U.S. economy.

"I think it's very constructive and what I think it shows to this country and to the rest of the world [is] that our central bank is nimble and able to move quickly," he said.

Investors didn't appear to share this sentiment. Stocks plunged at the open Tuesday morning, following two straight days of massive selloffs abroad. But stocks bounced off their lows as the morning progressed.

"You can get into a debate as to whether we're in a recession or not, but it's a really turbulent period right now and that makes it difficult for investors to figure out what to do," said Phil Dow, director of equity strategy with RBC Dain Rauscher.

Dow said the rate cuts are a welcome sign that should eventually help to stabilize the markets but he cautioned that stocks, particularly beaten down financial services companies, could still see more pain.

Along those lines, Rich Yamarone, chief economist with Argus Research, added that the Fed may be hitting the panic button, "There is no economic reason that the Fed couldn't wait until next week to cut rates," he said. "Something bigger is looming."

Yamarone suggested that the Fed might be worried that the problems facing banks and mortgage lenders are going to get worse very soon.

Before Tuesday, the Fed had cut the fed funds rate by a full point since September. Investors have been clamoring for more - and bigger - rate cuts hoping that they would kick-start a moribund economy and encourage businesses and consumers to spend.

More cuts: And the Fed is still widely expected to aggressively cut rates again at its Jan. 30 meeting. According to futures listed on the Chicago Board of Trade, investors are pricing in an 66 percent chance that the Fed cut another half-point.

"This was a big step but there is still more to go," said Keith Hembre, chief economist with First American Funds. Hembre thinks that the Fed will cut the fed funds rate to at least 2.5 percent within the next few months.

Fed lending has helped: The Fed has also loaned $70 billion to banks through a series of three auctions since December to help mitigate the effects of the credit crunch on Wall Street. That appears to be working as the Fed said Tuesday that "strains in short-term funding markets have eased somewhat."

Government "stimulus" plan: President Bush and Congress are also working on an economic stimulus package to help beleaguered consumers. The plan is widely expected to include payments to consumers, and tax breaks to spur investments by businesses.

Too little, too late? Despite these efforts, markets have plunged so far in 2008. At this point, Hembre said, it's probably too late for the Fed to prevent a recession - he said it takes several months for rate cuts to have an impact. But he added the Fed's efforts could help to make a recession brief.

"This rate cut certainly leads to a better outlook in 2009, but it may not have any effect on the first quarter or even first half of this year," Hembre said.

Or too much? Still others think the Fed needs to proceed cautiously, especially since it's fair to argue that aggressive rate cuts during 2001 may be the reason why banks are in the subprime mortgage mess they are in now.

William Poole, president of the Federal Reserve Bank of St. Louis, voted against the current rate cut. According to the Fed's statement, Poole did "not believe that current conditions justified policy action before the regularly scheduled meeting next week."

Fed board member Frederic Mishkin did not participate in the emergency meeting.

In addition, high prices of oil, gold and other commodities, coupled with a weak dollar, are a sign that inflation is not necessarily dead. One market strategist said he thinks the Fed made a mistake by cutting rates so drastically since it could lead to bigger inflation worries down the road.

"The Fed is sacrificing the U.S. dollar, which may well compound our problems in the future. I think the auctions are a more precise way to alleviate credit issues," said Haag Sherman, managing director of Salient Partners, an affiliate of investment firm Sanders Morris Harris.