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Wednesday, 18 April, 2001, 15:30 GMT 16:30 UK
Q&A: Why did the Fed cut rates again?

The Federal Reserve, the US central bank, has decided to cut interest rates for a fourth time this year. BBC News Online's Steve Schifferes explains why the decision was taken and what effect it will have.

Why has the Federal Reserve cut rates again?

The US central bank has decided to act to reassure markets, businesses, and consumers about the economy.

After eight years of strong economic growth, the US economy began a sharp slowdown in the last few months of 2000, which has been reflected in a sell-off in the stock market.

Now, despite three interest rate cuts, company profits are under severe pressure, with growing evidence of corporate layoffs and a reduction in company investment, especially in the high-tech sector..

Business and consumer confidence is fragile, and there are fears that high debts could cripple future spending.

The hope is that lower interest rates will encourage businesses and consumers to spend more, and reduce the burden of debt.

What difference will it make to stock markets?

US stockmarkets have gone into a tailspin this year, with major indices down some 20% since January.

The US high-technology index, the Nasdaq, has fallen by more than 60% since its peak one year ago.

Investors fear that the US recession will reduce company profits, and that shares have been too expensive, especially high-tech companies.

An interest rate cut could help in two ways.

First, if it helps the economy to recover, it should help profits recover in the long term.

In the short-term, however, a fall in interest rates also makes shares more attractive as an investment compared to bonds, the other main financial investment.

Bonds pay a fixed rate of interest, so with lower interest rates they become more expensive.

But in recent weeks, stock markets have had a brief recovery, and the Fed intervention seems to be timed to encourage that trend.

What do lower interest rates mean for households?

In general, an interest rate cut makes it cheaper to borrow money - such as mortgages - but also reduces the income savers receive.

US households borrowed heavily during the economic boom, using their rising share prices as collateral.

However, unlike in the UK, most US households have fixed, not variable rate mortgages, and so they only receive a reduction from lower interest rates when they remortgage.

There are also many more shareholders in the US, whose wealth is directly linked to the rise and fall in share prices.

That may explain why the Fed believes that preventing too sharp a fall in the level of stocks is the key to restoring consumer confidence in the United States.

Does this mean further rate cuts ahead?

The US Fed is acting very aggressively by cutting rates four times in the past three months.

Even during the Asian financial crisis, the Fed only cut interest rates three times to try and stabilise the world financial system.

And although stock markets have fallen sharply, it is still unclear how deep and long-lasting the overall economic slowdown in the US will be.

And it is unclear whether interest rates cuts alone can restore the fortunes of the stock market, given the bad news on profits.

The Fed may need to act again in order to kick-start the economy.

Other central banks, like the Bank of England and the European Central Bank, are also expected to cut interest rates soon.

How quickly do interest rates work?

Because households and businesses only adjust their spending plans infrequently, a rate cut will not necessarily have an immediate effect on the economy.

Most economists believe that it could take 6 to 9 months before an interest rate cut changes spending patterns.

However, at least the advantage of interest rates is that they are implemented immediately.

The Bush administration also wants Congress to cut tax rates to help stimulate the economy.

However, the legislation may take until the end of the year before it becomes law - and people might not see the benefit in their tax returns until April 2002.


Terror's impact

Signs of a slowdown

Rate cuts

Analysis

Key players

FULL SPECIAL REPORT
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