Fed Rate Cut Boosts Stocks; Another Cut Coming?

Stock prices Tuesday had their biggest one-day gain in five years. Prices jumped after the Federal Reserve decided to cut a key interest rate by three-quarters of a percentage point. Fed policymakers said they remain concerned about the slowing U.S. economy and suggested that they may cut rates again.

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Yesterday's stock market gains could be a sign of recovery, or they could just be a brief break in a long run of bad news. Either way, in a single day, stock owners got back some of the value they've lost in recent months. Standard & Poor's broad index of major stocks was up more than four percent. Prices jumped in part because the Federal Reserve cut a key lending rate.

The Fed suggested yet another rate cut could be coming, and that's just one part of an unorthodox effort to hold back a market panic. NPR's Jim Zarroli reports.

JIM ZARROLI: The Fed painted a gloomy picture of the economy. It said the labor market has softened, consumer spending has slowed, credit conditions have tightened and financial markets are stressed. To keep the economy from weakening any further, it said it was cutting the federal funds rate by three-quarters of a percentage point, or 75 basis points.

That was less than some investors had hoped for, but still high by historic standards. Stuart Hoffman is chief economist at PNC Financial Services Group.

Mr. STUART HOFFMAN (Chief Economist, PNC Financial Services Group): I think with the Fed still mostly focused on the economy, but looking inflation at of the corner of its eye, I think they decided that let's go with a somewhat compromised 75-basis-point rate cut, leave the door open for a further rate cut, maybe next month.

ZARROLI: That policymakers did express concern about inflation pressures and two members dissented, saying they favored a less aggressive move. But the Fed made clear it's ready to err on the side of doing too much rather than too little. Over the past two weeks, the Fed has kicked into high gear. It engineered the acquisition of Bear Stearns at a fire sale price by JPMorgan Chase, an acquisition backed by federal money.

The Fed also said it would allow banks and other financial institutions to buy Treasury bills using their bad mortgage debt as collateral. That lets them improve their balance sheets by trading bad debt for good. Economist Dean Baker says that presents something of a risk to the Fed.

Mr. DEAN BAKER (Economist): If any of them actually are in bad shape and are enable to repay the loans, then the collateral is likely not going to be equal to the full value of the loans.

ZARROLI: And when one of the borrowers defaults, the public indirectly foots the bill. Baker points out that under the terms announced by the Fed, the public won't know which banks take advantage of the lending program.

Mr. BAKER: I'd like to see those be public. If there's a stigma attached, well, that's the way it goes. You know, people should know if Citigroup or one of the other big banks is relying on the Fed in a very big way to borrow reserves. We should know that.

ZARROLI: The Fed also decided to extend credit to so-called non-depository institutions, like brokerage houses and investment banks. Unlike banks, which are regularly audited by the Fed, these other firms aren't tightly regulated by the U.S. government. So it can be tough for the public to know the extent of the liabilities the Fed is taking on.

But Baker says the Fed does deserve some credit for stabilizing the financial markets this week.

Former Fed economist Anne Owen, a professor at Hamilton College, says there are risks to the Fed's decision to extend borrowing to so many Wall Street firms. If too many defaults take place and the Fed goes through its reserves, it would have to print money, which is highly inflationary. But Owen says that's unlikely, and she says it's a risk the Fed has to take.

Professor ANNE OWEN (Economist, Hamilton College): In the long run, this is something that you would not want to see occurring. But, again, I think the Fed is in a tough position. They have to do something because the short-term consequences of them not doing something could be very bad.

ZARROLI: Owen says the unprecedented nature of the current crisis means the Fed has to do what it takes to keep the economy going. That means using traditional methods, like rate cuts. But increasingly, it also means trying less orthodox measures.

Jim Zarroli, NPR News, New York.

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Shedding Light on the Latest Fed Rate Cut

Traders on Wall St. i i

Traders work the floor of the New York Stock Exchange after Federal Reserve policymakers announced a cut in the federal funds rate. Hiroko Masuike/Getty Images hide caption

itoggle caption Hiroko Masuike/Getty Images
Traders on Wall St.

Traders work the floor of the New York Stock Exchange after Federal Reserve policymakers announced a cut in the federal funds rate.

Hiroko Masuike/Getty Images

The Federal Reserve policymakers on Tuesday cut the federal funds rate by three-quarters of a percentage point, less than what many in the financial markets wanted. But it was still an aggressive move by historic standards, and it underscores how concerned most Fed officials are about the economic slowdown.

In cutting the federal funds rate, the Fed said the outlook for economic activity had weakened: Consumer spending has slowed and labor markets have softened. Meanwhile, credit conditions have tightened and housing activity has contracted. All of these conditions are likely to weigh on growth for months ahead.

The rate cut follows a weekend in which the Fed extended credit to new kinds of financial institutions and engineered the bailout of investment bank Bear Stearns.

"The Fed is using sort of the blunt force of a funds rate cut to help provide growth for the economy. At the same time, [the Fed is] augmenting that with these other very specific types of activities to provide liquidity where it's needed most," says Stuart Hoffman, chief economist at PNC Financial Services.

In its statement on Tuesday, the Fed said downside risks to economic growth remain, which is usually taken by economists to mean the Fed may cut rates even further. But the statement included some anxious words about price pressures: It said inflation has been elevated and some indicators of inflation expectations have risen. That suggests some Fed members may have been ambivalent about the size of the cut.

And indeed, two members dissented, saying they wanted less aggressive moves.

"When you get two dissents, this was probably a very dicey discussion," says Hoffman.

A Mistake?

Tuesday's cut is the second of the same size this year. It brings the rate down to 2.25 percent. The rate was 5.25 percent as recently as last September.

Fed officials are hoping that by making money cheaper to borrow, they'll encourage investment and keep the economy from tipping into a recession — if it's not already there.

But economist Richard Yamarone of Argus Research believes the cuts in interest rates are a mistake. He says the problem right now isn't that money is too expensive. Instead, Yamarone says the real problem is widespread mortgage-market losses, which have hurt confidence in the major banks and made people nervous about investing in the U.S. economy.

"Many of these balance sheets in these Wall Street trading firms have worthless paper, and the Fed cutting the federal funds rate by 75 basis points is not going to cure that," he says.

Yamarone says people aren't going to invest their money if they are worried about the economy, no matter how low interest rates fall. And he says the steady drop in rates may actually hurt the economy in the long run.

Federal Reserve officials kept interest rates artificially low after the Sept. 11, 2001, terrorist attacks and that helped create the housing bubble. Yamarone says the same thing may be happening now.

"Excessive rate cuts like this are what brought the hangover," according to Yamarone, and the Fed "just gave us a little hair of the dog that bit us."

But that's a minority view right now. Most economists say the sharp slowdown in growth and the troubles in the banking sector represent a big threat to the economy. Fed policymakers, they say, need to do whatever it takes to avert that.

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