[NYTr] Markets "Soar" After Fed Cuts Key Rate by a Half Point

[All the News That Doesn't Fit]

The New York Times - Sep 18, 2007
http://www.nytimes.com/2007/09/18/business/18cnd-fed.html

Markets Soar After Fed Cuts Key Rate by a Half Point

By EDMUND L. ANDREWS and JEREMY W. PETERS

WASHINGTON, Sept. 18 — The Federal Reserve today lowered its benchmark
interest rate by a half point, a forceful policy shift intended to
limit the damage to the economy from the recent disorder in the housing
and credit markets.

While an interest rate cut was widely expected, there had been profound
uncertainty about whether the Fed would choose a more cautious
quarter-point reduction. But the bolder action and an accompanying
statement, both approved by a unanimous vote of the central bank’s
policy-setting committee, made it clear that the Fed had decided the
risks of a recession were too big to ignore.

“Developments in financial markets since the committee’s last regular
meeting have increased the uncertainty surrounding the economic
outlook,” the central bank said. Signaling that it might cut rates more
if necessary in months ahead, it said it would “continue to assess” the
economic outlook and “act as needed to foster price stability and
sustainable economic growth.”

The decision, which reset the overnight lending rate between banks to
4.75 percent, was the Fed’s first rate cut in four years.

Stocks immediately soared. The Dow Jones industrial average registered
its biggest one-day gain in almost five years, closing at 13,739.39, up
335.97, or 2.5 percent. The Standard & Poor’s 500-stock index rose
nearly 3 percent.

For consumers, the Fed’s move could mean lower borrowing costs on for
mortgages and automobile loans. But the impact may be muted, because
investors remain deeply anxious about the credit quality of mortgages
and other long-term loans. The main problem in the past month has not
been high rates so much as the availability of capital to complete
deals.

In a separate move to bolster the banking system, the Fed also said
today that it had cut its discount lending rate, which applies to
short-term emergency loans to banks, to 5.25 percent — also a
half-point cut.

This was the Federal Reserve’s most abrupt reversal of course since
January 2001, when it suddenly slashed rates at an unscheduled
emergency meeting because of signs that the economy was slipping into a
recession. The last half-point cut in the federal funds rate came in
November 2002.

Economists said that the Fed’s move today was similarly pre-emptive.
“Monetary policy makers are worried about growth being seriously
compromised and are prepared to take whatever prudent steps they can to
avoid a deep slump,” said Joshua Shapiro, chief United States economist
for MFR.

Some aspects of today’s Fed’s move could fuel inflation fears. Gold, a
traditional investment safe haven in times of inflation, soared
immediately after the Fed’s decision was announced. As United States
interest rates became less attractive for investment, the value of the
dollar against the euro touched a new low before recovering slightly,
and oil prices continued to climb even further above $80 a barrel.

In the stock market, financial stocks posted the biggest gains,
reflecting the fact that banks now will face lower borrowing costs,
which should help drive profits higher.

“Shock therapy,” was the assessment of Ethan Harris, chief economist at
Lehman Brothers.

But Mr. Harris cautioned that the Fed stopped short of signaling a firm
commitment to more rate reductions. While it dropped its previous
statement that inflation was still the “predominant concern,” which
would argue against using lower rates to stimulate the economy, the Fed
said that “inflation risks remain” and that it would “monitor inflation
developments carefully.”

David Rosenberg, chief North American economist at Merrill Lynch, said
the Fed appeared deliberately ambiguous about its readiness to cut
rates even further at its policy meetings in October and December.

“The Fed kept its cards much closer to its vest than anyone would have
guessed,” Mr. Rosenberg said. “It’s not at all clear they think they
have more to do.”

As recently as six weeks ago, the central bank was still predicting
“modest” growth for the economy and warning that inflation remained its
“predominant concern.” As in 2001, the Fed’s move today came after a
panic in financial markets and the collapse of a speculative bubble.
This time, the panic is in credit markets spooked by dubious mortgages
on inflated housing prices. Back then, it was the stock market that
crashed, initially because the air went out of inflated dot-com stocks.

In the jargon of economists, the turmoil in both cases represented a
sudden “repricing” of risk. Other signs have surfaced recently that the
financial market upheaval may not be isolated. Earlier this month, the
Labor Department reported the first monthly loss of jobs in four years.
Employers eliminated 4,000 positions in August, a factor that may have
played a role in the Fed’s decision today.

By today, it seemed clear that Fed policy makers were no longer
debating whether to reduce rates but how much to lower them. Despite
the seemingly narrow debate — whether to lower the overnight federal
funds rate by one-quarter of a percent or by one-half of a percent —
the uncertainty about this policy meeting was higher than any other in
the past four years.

The debate within the Fed was all about risk probabilities: what were
the odds the twin meltdowns in housing and mortgage markets would tip
the overall economy into a recession later this year? If policy makers
cut rates too cautiously, they risked a recession; if they cut them too
much or too early, they risked stoking inflation.

Economists said what appeared to push the Fed to cut rates by a half
point were the dismal job market numbers from August.

“I think that was a real eye-opener for them,” said Joshua Shapiro,
chief United States economist for Maria Fiorini Ramirez, an economic
consulting firm in New York. “The only ammunition the consumer has left
is from the labor market. If income growth is compromised here because
the labor market is weakening, then you’ve got a serious problem.”

Peter E. Kretzmer, senior economist for Bank of America, said that by
cutting rates a half point, Fed policy makers may have been hoping to
draw the investors’ attention away from the central bank.

“I think they kind of cleared the decks,” he said. “They said we’re
going to be a little bold and remove at least one source of
uncertainty. And that is the source that says ‘What is the Fed
thinking, and when are they move again?’ Maybe they can take the
market’s mind off the Fed for a little while.”

Ben S. Bernanke, chairman of the Federal Reserve, had made it clear
over the past month that the Fed did not simply want to rescue Wall
Street investors who made bad bets or real estate speculators who
bought properties on the assumption that prices would keep skyrocketing.

But Mr. Bernanke also pledged that the Fed would act if the dislocation
in financial markets or the downturn in housing threatened to derail
overall growth.

Just a few hours before the central bank announced its decision, new
statistics indicated that the pace of home foreclosures is
accelerating. RealtyTrac of Irvine, Calif., reported that foreclosure
filings — from default notices and auction sales to bank repossessions
— were 36 percent higher in August than in July and 115 percent higher
than one year ago.

The Labor Department also reported today that producer prices fell by
1.4 percent in August — much more than expected — because of slumping
energy prices. That was positive news on inflation, but analysts said
it was unlikely to have much influence on the Fed because the "core”
measure excluding energy and food prices increased 0.2 percent,
slightly more than expected.

Except for the housing downturn, which Fed officials admit is much more
severe than they had expected, the evidence of a recession in the real
economy is ambiguous. Global economic growth is much stronger than in
2001, and American exports have climbed about 14 percent over the last
year.

Instead of the United States’ being the world’s engine of growth, the
global economy could now become the engine of American growth.

For the last four years, the Federal Reserve has telegraphed its
intentions months in advance as it pursued a gradualist approach of
slow but steady adjustments in monetary policy. It advertised its
intention to raise rates gradually many months before it actually did
so in June 2004, and then raised rates in well-signaled increments at
each policy meeting over the next two years.

By contrast, Wall Street analysts were sharply divided as of early
today about how much the Fed would cut rates and what it would say in
its statement about the economic outlook.

A smaller rate reduction posed a risk of moving too slowly if the
economy was indeed in danger of stalling. But a bigger rate reduction
could have been taken as a sign of Fed panic, and it added to the risk
of stoking inflationary pressures that the central bank had just begun
to tamp down.

But the evidence so far is inconclusive. In August, for the first time
in four years, the Labor Department estimated that the number of jobs
declined slightly. It also reduced its estimates of job growth in June
and July, suggesting that the labor market weakened even before credit
markets froze up in early August.

But other indicators — on consumer spending, consumer confidence and
export growth — point to a continuation of modest growth.

Right or wrong, today’s decision will be a defining moment for Mr.
Bernanke, the former economics scholar at Princeton who became Fed
chairman in February 2006.

Many Wall Street economists place the odds of a recession at about one
in three or somewhat higher. Alan Greenspan, who preceded Mr. Bernanke
as Fed chairman, puts the odds at somewhat more than the one-in-three
that he estimated earlier this year.

The Fed’s course change has been under way since early August, when
fears about huge losses on subprime mortgage loans and continued
downturn in housing caused a much broader panic in credit markets.

The resulting credit crunch has now affected all but the safest home
mortgages, and also greatly reduced the ability of private equity funds
and hedge funds to borrow money at low rates. Many banks, which had
been planning to resell their loans into the giant market for tradable
commercial debt securities, are now being forced to absorb loans that
the securities markets will no longer take.

On Aug. 17, the Federal Reserve moved to ease the liquidity crisis by
encouraging banks to borrow money through its “discount window,” a
program originally created as an emergency source of overnight funds
for banks in a cash squeeze.

But by most accounts, the turmoil in credit markets has abated very
little. The market for subprime mortgages has all but disappeared, and
demand for all forms of “asset-backed commercial paper,” which are
securities backed by mortgages, credit card debt, company receivables,
remains very weak.

Vikas Bajaj contributed reporting from New York.