Super-Sized Rate Cut Spurs Super-Steep Rally; Dow Soars Nearly 336 Points

By Jason Simpkins

Staff Writer

When it came right down to it yesterday (Tuesday), U.S. investors awaiting a central bank decision on short-term interest rates investors were expecting the standard Value  (investing) Meal. But U.S. Federal Reserve policymakers surprised them with the Happy Meal instead.

The result: A Super-sized stock surge, representing the biggest single-day rally in stocks in five years.

Instead of the widely expected quarter-point cut in short-term interest rates investors had been expecting, the central bank’s policymaking Federal Open Market Committee (FOMC) stunned investors when it cut the benchmark Federal Funds rate by half a percentage point, dropping it to 4.75%. The first Fed Funds rate cut in four years came as a great reassurance to many troubled investors and market analysts who have worried that a growing global credit crunch was signaling the onset of a recession.

The Fed also cut its Discount Rate – what banks pay to borrow directly from the Federal Reserve – by a similar half a percentage point, bringing that key rate down to 5.25%.

The central bank last lowered the discount rate by half a point on Aug. 17. That was part of a campaign to restore confidence in the financial markets with direct injections of liquidity, in the hope that a potentially inflationary Fed Funds rate cut could be avoided.

“The FOMC looks like it is finally getting it,” said Joel L. Naroff, president and chief economist for the Holland, Pa.-based econometrics firm, Naroff Economic Advisors Inc. “After consistently underestimating the extent of the slowdown in housing and the implications of the subprime [mortgage] meltdown, the [central bank] committee moved aggressively to start addressing the constraining effects of the credit crunch. The half-point reduction in the funds rate was needed.”

Investors showed their approval by sending stocks skyward almost immediately after the committee’s 2:15 p.m. announcement. The Dow Jones Industrial Average soared 335.97 points, or 2.51%, to close at 13,739.39. The last time this bellwether blue-chip index rose more than 300 points was Oct. 14, 2002, when the 30-stock Dow soared 378 points.

The tech-laden Nasdaq Composite Index soared 70 points, or 2.71%, to close at 2651.66. The broader Standard & Poor’s 500 Index surged 43.13 points, or 2.92%, to finish the day at 1519.78.
The statement added that the central bank will “act as needed to foster price stability and

In a statement that accompanied the rate-reduction announcement, the committee said that yesterday’s rate-cutting “action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets.” sustainable economic growth.”

A lot has gone wrong in the past few months, beginning with the sonic boom-like shock wave that emanated from the popping of the U.S. housing bubble.  Rising defaults on subprime mortgage loans destabilized credit markets and asset backed commercial paper contracted by the most we’ve seen in seven years.

Investor confidence wavered further as it became evident that problems originating in the housing market had boiled over to other aspects of the economy. The Labor Department said Sept. 7 that employers cut 4,000 workers in August. It was also revealed that job growth hit a three-month slide beginning in June. Retail sales and industrial production also failed to meet analysts’ expectations in August.

But it seemed as if the circumstances aligned just enough to spawn the half-point cut in interest rates. Inflation, which was very much the Fed’s focus until recently, has seemingly receded.

The Fed’s preferred price gauge, which excludes food and energy costs, rose 1.9% from a year earlier staying within the favorable 1% to 2% window. Also, the Labor Department said yesterday that producer prices fell 1.4% in August, which was more than many economists had predicted.

Many will view this rate cut as a strong move by the Fed, showing it’s ready and willing to be aggressive in getting the economy back on track. However, some might suggest that Bernanke and the Fed caved to pressure from Wall Street and did little more than bail out troubled investors.

[For an analysis of the rate cuts, and several investment suggestions by Martin Hutchinson, Money Morning’s director of global investing research, click here. For insights into the fallout of the rate cuts, and still additional investing possibilities, click here to read a special commentary by Keith Fitz-Gerald, our chief Contributing Editor.]


Related News and Story Links: Wall Street delighted by aggressive rate cut.

Money Morning News: Fed Cuts Discount Rate; Stocks Rebound.