Fed faces risks of inflation, recession

John W. Schoen Senior Producer • Profile • E-mail

Tuesday’s aggressive interest rate cuts by the Federal Reserve were intended to calm the financial markets and help give a boost to a sagging U.S. economy battered by an ongoing recession in the housing industry.

It will take months — or longer — to know if the decision was the right one. In the meantime, the Fed still faces risks no matter what move it makes next.

With a bolder move than many Fed watchers had expected, the central bank slashed a half-percentage point from its target federal funds rate — used as a benchmark for a variety of short-term consumer and business loans, including the prime rate. The first cut in four years brought the fed funds rate down to 4.75 percent, and banks followed by lowering the prime rate to 7.75 percent.

Fed Chairman Ben Bernanke and his colleagues also slashed a half-point off the so-called “discount rate” on direct loans to banks.

Financial markets and bankers cheered the move. The Dow Jones industrial average rose 335 points for its biggest gain in five years; prices of short-term Treasury securities also surged, reducing market interest rates.

“God bless the greatest central bank in the world,” said Jon Evans, chief executive of Atlantic Central Bankers Bank, which serves community banks in five states. “This is great news for the economy and the consumer.”

CNBC video Cramer: 'These guys get it!!!!!' Sept. 18: Jim Cramer is pounding on the podium again over the Fed's moves, only this time he likes them. Erin Burnett talks with the "Mad Money" host. CNBC

Many Fed watchers had been expecting a more modest quarter-point cut. In announcing its decision the Fed said that “will act as needed to foster price stability and sustainable economic growth."

Those twin goals — containing inflation while dodging recession — highlight the balancing act the central bankers are trying to pull off. A course of limited or gradual rate cuts might not have been enough to keep the slowing U.S. economy from being dragged into a downturn by the housing recession.

On the other hand, rapid, aggressive cuts could spark another round of the kind of easy credit that created the housing bubble — and risk eroding gains in the Fed’s hard-fought battle to keep inflation under control.

For the moment, fears of a housing-lead recession and the potential for more turmoil in the financial markets seem to be governing the Fed’s thinking.

"The tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally," the Fed's rate-setting Open Market Committee said in its statement Tuesday. "Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets."

Even before Tuesday’s meeting, the Fed spent much of August trying to push money into the banking system by encouraging banks to borrow through its so-called discount window. Those moves helped provide some calm from the storm that swept through the financial markets a month ago.

Assessing the health of the economy is probably the Fed’s toughest task at the moment. On Tuesday, the FOMC  got two more pieces of data to chew on before making its latest rate policy announcement. Those two reports provided fresh news from the two fronts of the battle being fought by the Fed — that of keeping the markets and the economy on an even keel without setting the stage for higher inflation.

The Labor Department reported that wholesale prices fell by 1.4 percent in August, led by a big pullback in energy prices. Even without that drop, so-called "core" inflation rose just 0.2 percent for the month.

Meanwhile, the ongoing mortgage mess continued to widen in August. As financial markets remained skittish about the risk of rising defaults, the number of foreclosure filings more than doubled from a year ago and jumped 36 percent from July, according to a RealtyTrac, a Web site that specializes in foreclosures.

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