The U.S. Federal Reserve reduced the benchmark U.S. lending rate by a quarter point – from 2.25% to 2% – yesterday (Wednesday), and then hinted that it will take a break from one of its most-aggressive rate-cutting campaigns in decades.

“The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity,” the policymaking Federal Open Market Committee (FOMC) said in the statement announcing the interest-rate move. Central bank policymakers also said that “recent information indicates that economic activity remains weak” before going on to say “uncertainty about the inflation outlook remains high” and noted that the Fed would continue to monitor both economic growth and inflation closely.

The Fed launched this rate-cutting campaign on Sept. 18, not long after it became clear that the U.S. subprime mortgage meltdown was having a global impact. The reason: Banks in Germany and France had – for whatever reason – invested in debt obligations that were backed by subprime mortgages. And when the subprime market blew up, so did the holdings at those foreign banks.

Before the crisis broke, and even in its early weeks, Fed Chairman Ben S. Bernanke and other U.S. leaders repeatedly maintained that the problem was limited in scope and that no real “crisis” would evolve. Today, an estimated $312 billion in write-downs and credit losses later, the central bank has slashed interest rates seven times and helped engineer the bailout of The Bear Stearns Cos. (BSC) by JPMorgan Chase & Co. (JPM).

Yesterday marked the seventh time since mid-September that the U.S. central bank reduced the Federal Funds rate, the interest rate that banks with excess reserves charge one another for overnight loans. The Fed Funds rate also serves as the benchmark for the Prime Rate, the base rate that commercial banks use to price loans to their best and most-credit-worthy customers. Wachovia Corp. (WB) and other lenders pared their Prime Rates by a similar quarter point – reaching 5% – shortly after yesterday’s Fed action.

Stocks soared in early trading. But then the markets shed those gains following the announcement of the expected quarter-point cut and ended mostly flat. The blue-chip Dow Jones Industrial Average Index was down 11.81 points (-0.09%), to trade at 12,820.13. The tech-laden Nasdaq Composite Index shed 13.30 points (-0.55%), to reach 2,412.80. And the broader Standard & Poor’s 500 Index decreased 5.35 points (-0.38%), to hit 1,385.59.

“The markets pretty much knew what was coming and what we wanted to see were the changes in the statement,” said Joel Naroff, president and chief economist of Naroff Economic Advisors, in a note to clients. “There were some, but the Fed still left itself plenty of wriggle room to do what it pleased.”
 
Central bank policymakers have slashed the Fed Funds rate by a total of 3.25 percentage points from its starting point of 5.25% level in mid-September, and the comments that accompanied yesterday’s announcement seemed to indicate the committee was content to step back and allow rate reductions to work their way through the U.S. economy.

The committee also reduced the lesser-known Discount rate (the rate charged at the Fed’s discount window) by a quarter point to 2.25%.

A Look to the Future

The committee did leave some room for future cuts by stating it “will act as needed to promote sustainable economic growth and price stability.”

Some analysts took the statement as a clear signal the Fed plans to pause.

“We do not expect to see a rate cut at the next few meetings without a substantial contraction of the economy,” Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York, told Bloomberg News. “We are not yet to Memorial Day weekend, but the Fed effectively told us today to take the summer off.”

But the language was ambiguous enough to leave the statement open to some interpretation.

Ian Shepherdson, North American economist at High Frequency Economics, sees it differently. The Fed may “intend” to stand back and take a breather, but if a series of reports show that the U.S. economy is weakening, all bets are off.

“If the data deteriorates further, as we expect, the Fed will ease again,” Shepherdson said in a note to clients. “Today’s statement is important – [but only] today. Tomorrow, the numbers are back in charge.”

Steve Gallagher, chief economist at Societe General SA (OTC: SCGLY) in New York, called the statement a “soft non-binding pause.”

Not a Unanimous Move

Two FOMC policymakers reprised their dissenting votes. Both Richard Fisher, president of the Federal Reserve Bank of Dallas, and Charles Plosser, president of the Federal Reserve Bank of Philadelphia, had opposed the last rate reduction. Yesterday, they were again the only voices of dissent against yesterday’s rate cut, opting instead to hold rates steady.

“The two dissents show they are still worried about inflation,” Diane Swonk, chief economist at Chicago-based Mesirow Financial Holdings Inc., told Bloomberg “This is a Fed ready to watch from the sidelines.”

Playing to a Global Marketplace

The real question investors have now is this: What happens next?

Whatever the answer turns out to be, it’s almost certain to have a global spin – and a global impact. And that answer is likely to contain two other terms: Inflation and the dollar.

In its commentary, the Fed did warn that “some indicators of inflation expectations have risen in recent months.”

Indeed, many would argue that the Fed itself – with its ambitious rate-cutting campaign – has actually fueled domestic inflation and exacerbated the decline of an already weak greenback.

Here’s why some analysts believe that. The central bank’s preferred inflation barometer – the personal consumption expenditures price index – rose at only a 2.2% annual rate in the first quarter. But that indicator excludes food and energy prices – the most volatile and steeply climbing portion areas in the U.S. economy.

Officially, the U.S. inflation rate stands at about 4%, though many experts – including Money Morning Contributing Editor Martin Hutchinson – believe the actual U.S. inflation rate is much higher.

In fact, with yesterday’s latest rate cut by central bank policymakers, anyone who has closely followed the steep-and-steady increases in energy, food prices, commodities, healthcare, and a university-level education may find it tough to argue that prices aren’t headed even higher, still.

Because interest rates abroad are higher than they are in the United States, capital has moved out of the U.S. market and into the higher-yielding regions. The result: The dollar has dropped precipitously.

The fact that most central banks abroad have held rates steady even as the Fed pared U.S. rates has only exacerbated the greenback sell-off.

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