Fed likely to prefer lending over interest-rate cuts

The Fed cut rates to 2 percent this week from 5.25 percent in September. With the value of the dollar falling against foreign currencies, and rising commodity costs pressuring consumers at the gas pump and the grocery store, the central bank wants to steer clear of actions that will push prices up even more.

By lending directly to banks, the Fed can provide capital that banks need to lend to consumers and businesses without fueling higher prices in industries that don't, said Bill O'Grady, chief investment strategist at Wachovia Securities.

"The more they make liquidity available through new channels, the less they need to cut the federal funds rate," O'Grady said.

By relieving the seizure plaguing financial markets, the Fed hopes it can free up the cash many banks are hoarding. This would presumably encourage banks to lend their money out through mortgages or business or car loans.

Recent months have seen surging food and energy costs. Wall Street is concerned that the threat of inflation and the persistent struggles of the housing market would force consumers, who account for about 70 percent of U.S. economic activity, to spend less.

The Fed said Friday it would boost the amount of emergency reserves it supplies to U.S. banks to $150 billion in May, from the $100 billion it supplied in April. The Fed took this action and several other moves to boost credit in coordination with the European Central Bank and the Swiss National Bank.

The Fed has committed about $600 billion in loans to banks, an amount that represents perhaps half of all the distressed debt in the market, said Lehman Brothers credit strategist Amitabh Arora. This helps moderate the risk that a struggling bank might have to auction off its investments to avoid bankruptcy, he said.

The latest moves are part of a series of actions the Fed has taken since the credit crisis struck in August. The market has responded in the past six weeks, showing signs that confidence is creeping back into the system. Stocks are up more than 10 percent and prices for Treasurys and gold which typically rise times of distress have slipped.

While other factors have contributed to the relief rally in the past few weeks, Arora said these actions and the Fed's assistance in bailing out Bear Stearns Cos. have helped.

But even after the Labor Department said the U.S. economy shed 20,000 jobs last month fewer than expected stocks had a lukewarm response. That suggests that, like the Fed, investors aren't sure the credit crisis has been contained.

The report was a relief to Wall Street, which expected payrolls to fall by 70,000 jobs. The unemployment rate fell to 5 percent from 5.1 percent. It was the fourth straight month of job losses, but the data signaled the economy might be resisting recession.

Dan North, chief economist at Euler Hermes, said he expects the Fed to cut rates one more time next month, by 0.25 percentage points, and then stop. The Fed's statement accompanying its decision this week carried a more hawkish tone on inflation suggesting Chairman Ben Bernanke is more worried about swelling prices and thus less inclined to slash rates, he said.

Rather than sustaining banks with badly needed loans, North thinks the Fed is "polluting the world with dollars," meaning making money so easy to obtain that the dollar is losing value.

The market is "awash in liquidity," North said. Plenty of companies have plenty of cash to lend or spend, North said.

"The Fed is trying a multitude of things," he said. "They're looking for ways other than lowering interest rates, but what's happening is they're just pumping liquidity into the system and it's not necessarily going to make the banks want to lend more."

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AP Business Writer Tim Paradis in New York contributed to this report.

(This version CORRECTS SUBS 2nd graf to correct 4.75 percent to 5.25 percent.)