Aggressive cut surprises investors but statement still wary of inflation
IN NEW YORK
THE US central bank sent a strong and decisive message to the world’s financial markets with a fifty basis point short term interest rate cut on Tuesday, that it intends to combat the economic effects at home of the global credit crunch on the US economy as well as to buttress the faltering confidence in the financial system worldwide.
In its accompanying statement, the Federal Open Market Committee said the action was needed to ‘help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time’.
The Fed’s decision to make its first rate cut in four years such a big one was reached unanimously by what had heretofor been a deeply divided interest rate policy making committee.
‘The FOMC looks like it is finally getting it,’ said Joel Naroff, president of Naroff Economic Advisors, reflecting the overwhelmingly positive sentiment on Wall Street. ‘After consistently underestimating the extent of the slowdown in housing and the implications of the sub-prime meltdown, the Committee made the right, aggressive move,’ he said. ‘I only hope this is the beginning and not just the end of its recession-fighting attitude.’
The move was clearly intended to inject confidence into fragile financial markets, Wall Street analysts said, and for one day at least, it worked in spades. Investors celebrated and the major US stock market indexes soared on the news of the fifty basis point reduction in both the federal funds rate and the discount rate which brings them down to 4.75 per cent and 5.25 per cent, respectively.
The Dow Jones Industrials registering a whopping 335-point or 2.5 per cent gain on the day. The stunning rally was even stronger on the broader S&P 500 index, which leaped by 43 points, or 2.92 per cent, as well as on the technology company-dominated Nasdaq Composite, where shares gained 2.7 per cent, a 70 point advance.
‘Wall Street got exactly what it was asking the Fed for,’ said Jim Awad, chairman of WP Stewart, a US$6 billion equity growth fund. ‘Traders and money managers have been screaming for a fifty point cut for the last two weeks, but I don’t think most investors expected the Fed to act as aggressively as it did, which is why you got such an overwhelmingly positive reaction on the stock markets. People were surprised, very happily surprised to see the Fed make such a big about-face and put the priority on ensuring liquidity in the capital markets over keeping inflation in check,’ he said.
Wall Street seemed intent on continuing the celebration for a second day, as stocks opened broadly higher following a big rally in Asia overnight. The Dow Jones industrials shot out of the gate at the opening bell, racing to a 86 point, 0.63 per cent gain in the first minutes of trading yesterday. The S&P 500 and Nasdaq Composite accelerated faster, advancing by 0.83 per cent and 0.71 per cent, respectively.
Tobias Levkovich, Citigroup’s chief investment strategist believes the market’s reaction to the Fed’s move will have more than short-term affects on share prices. ‘The decision to cut aggressively and the fairly clear language offered by the FOMC statement were meaningful salves for equity markets,’ he said, noting that daily moves of greater than 2 per cent, as occurred on Tuesday, are good indicators of strong future market performance as well. ‘This has been a bullish day on several levels,’ he said.
Still, Wall Street has already turned to its next big question: what’s next for the Fed?
‘The Fed noted that the action was ‘intended to forestall some of the adverse effects’ on the economy. Moreover, they also kept in the statements on upside inflation risks. We take these as a signal that they are not necessarily intending to reduce rates further which means that another rate reduction in October is not a certainty,’ observed David Rosenberg, chief US economist at Merrill Lynch.
Economists have already begun debating where the Fed goes from here and whether its fifty basis point cut is enough to keep the slumping US economy from an outright slump and a recession. Mr Rosenberg is in the camp of those favouring an additional cut, as is Mr Naroff, who said: ‘The Fed needs to keep taking necessary action to try to forestall a recession. One fifty basis point cut doesn’t necessarily do it for the economy. Even at 4.75 per cent, the Fed has not yet reached neutral. To stimulate growth, the funds rate should be cut to 4 per cent or less.’
Other economists, like Michael Darda, MKM Partners’ chief economist, said that chairman Ben Bernanke’s Fed should be loath to cut rates further, and must remain vigilant against the threat of inflation. ‘The inflation threat looms especially large because the dollar has been in decline against other major currencies. A declining dollar reduces consumers’ purchasing power and feeds inflation by making imports more expensive. The Fed has to be very careful not to provoke another bubble like the one that has led us to this crisis,’ he said.
Source: Business Times 20 Sept 07
