By William Patalon III
And Jason Simpkins
Money Morning Editors
The U.S. Federal Reserve cut its benchmark interest rate by less-than-expected three-quarters of a percentage point yesterday, a move that was designed to energize a badly flagging economy without causing inflation to spike or exacerbating the greenback’s decline.
Central bank policymakers yesterday reduced the key Federal Funds rate from 3% to 2.25%, the sixth time in seven months the closely watched benchmark has been shaved. Many analysts had been expecting a reduction of a percentage point – or even more – as such recent events as the near-collapse and subsequent Fed-led bailout of U.S. investment bank Bear Stearns Cos. Inc. (BSC) stoked fears that the U.S. financial system was ready to freeze up.
The policymaking Federal Open Market Committee (FOMC) has now cut the Fed Funds rate six times and slashed the Discount Rate for direct loans to banks eight times since August, when the subprime mortgage market collapsed and created a global credit crisis.
While the FOMC made it clear that inflation has grown as a concern, it still says that economic worries remain the biggest problem and emphasized that it was ready to act again if need be.
“Today’s policy action, combined with those taken earlier, including measures to bolster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity,” the FOMC said in a statement. “However, downside risks to growth remain. The committee will act in a timely manner as need to promote sustainable economic growth and price stability.”
U.S. stocks rallied the most in five years as earnings from key U.S. investment banks Lehman Brothers Holdings Inc. (LEH) and Goldman Sachs Group Inc. (GS) posted better-than-expected earnings – and allayed investor fears that the financial-services sector was headed for tens of billions in additional write-downs. [For an in-depth look at both firms’ financial results, check out our analysis of the Lehman and Goldman earnings reports in today’s Top News section].
The Standard & Poor’s 500 Index soared 54.14 points, or 4.2%, to 1,330.74 – its biggest increase since October 2002. The Dow Jones Industrial Average climbed 420.41, or 3.5%, to 12,392.66, its fourth-biggest point gain ever. The Nasdaq Composite Index increased 91.25, or 4.2%, to 2,268.26. It was the broadest advance since September, with 16 stocks advancing for every one that fell on the New York Stock Exchange.
Financial stocks in the S&P jumped 8.5% as a group, the most since September, and the top-advancing group among the 10 industry sectors. But the sector still is down 13% for the year after the top financial firms around the world have posted nearly $200 billion in credit losses and asset write-downs related to the collapse of the subprime mortgage market.
Although many analysts were looking for a rate reduction of a full percentage point or more, it’s highly likely that U.S. Federal Reserve Chairman Ben S. Bernanke found himself in a tough spot and had to make some concessions, said Joel Naroff, president and chief economist of Naroff Economic Advisors in Holland, Pa.
Here’s why. In announcing the rate reductions, central bank policymakers revealed that both Dallas Fed President Richard Fisher and Philadelphia Fed President Charles Plosser dissented in favor of less-aggressive actions. In fact, with the Fed’s increasing aggressiveness in recent months, there’s likely been a growing disagreement by at least a few of the members over the unorthodox strategies the central bank has employed, Naroff says.
“There had been hopes for a full-percentage-point reduction, but it is really hard to argue with what was done, especially given the dissent by Philadelphia Fed President Plosser and Dallas Fed President Fisher,” Naroff says. “Clearly, gaining a consensus was difficult and it is not good when two members vote ‘no’. Inflation worries remain central to these two presidents and the FOMC did note that [inflation has been on the rise]. What that probably means is that, as soon as it can, the FOMC will move quickly to unwind the sharp reduction in rates and the additions to liquidity in order to keep inflation in check.”
However, Money Morning Investment Director Keith Fitz-Gerald continues to believe that the central bank and FOMC policymakers are headed down a blind alley. In fact, he says that he’s seen this strategic package before – and says he knows it doesn’t work.
“While I'll take the euphoria that goes with a 75 point basis cut, I can't help but feel a terribly foreboding sense of déjà vu here,” Fitz-Gerald said. “The Fed appears to be making many of the same critical errors the Japanese Federal Bank made [as it worked to] bail out that country's companies in the early 1990s.”
Fitz-Gerald noted that “history shows that big up days in secular bear markets have a nasty history of turning into ‘bull bait’ [which draws in hopeful investors who are then picked clean when the bear-market trends resume]. Only when there is some serious follow-through from global traders will I believe the worst is behind us.”
It’s not just the aggressive rate-cutting campaign that’s created the internal dissent, it’s the increasingly aggressive strategies that the central bank is employing, Naroff and other analysts say.
The U.S. Federal Reserve – under the stewardship of central bank Chairman Ben S. Bernanke – is playing a much-more-involved role than usual in the U.S. economy’s health and operation.
Consider the moves made over the past week alone:
- Last Tuesday, Bernanke unveiled a financing arrangement to extract $200 billion in illiquid debt from the U.S. economy, replacing it with U.S. government bonds. The goal: To help breathe life back into the U.S. economy and the American capital markets. The strategy stoked investor confidence, if only for one day: Investors reacted by launching the biggest stock-market rally in five years. The Dow Jones Industrial Average Index posted a gain of more than 415 points.
- On Friday, the Fed jumped back into the fray, drafting JP Morgan Chase & Co. (JPM) to helpbail out Bear Stearns.
- Then on Sunday, the Fed called its most audacious play of all, announcing a financing arrangement through which JPMorgan will acquire Bear Stearns in a deal that’s valued at $236.2 million. As part of that arrangement, the central bank also agreed to fund up to $30 billion of Bear Stearns’ less-liquid assets. It also cut the discount rate.
- Finally, yesterday, central bank policymakers trimmed the Fed Funds rate.
Jump-Starting the U.S. Economy
The rate cut, at least, seems to be having the desired effect: Commercial banks last night started announcing reductions in their prime rate, with such institutions as Wachovia Corp. (WB) announcing they’d pared their prime-lending rate from 6% to 5.25%.
The prime rate is the interest rate banks charge their most creditworthy customers. It serves as a benchmark for determining market-lending rates. By cutting rates and making it cheaper for consumers and businesses to borrow, the central bank hopes to see spending increase enough to rejuvenate growth.
In that respect, the economy has been struggling. In the fourth quarter, gross domestic product (GDP) decelerated to a mild 0.6% pace.
And now, just two and a half months into 2008, many analysts believe the economy is already in the throes of a recession. In fact, U.S. Treasury Secretary Henry Paulson all but said as much on NBC's Today Show yesterday.
“There's no doubt that the American people know that the economy has turned down sharply,” Paulson said. “So to me much less important is the label that's placed on it today. Much more important is what we do about it.”
Payrolls fell for a second straight month in February as employers shed 63,000 jobs, the biggest monthly decline in five years. About 22,000 jobs were lost in January, revised up from the 17,000 originally reported. Retail sales dropped 0.6% in February after a 0.4% increase in January, proof that consumer confidence is waning as payrolls decline and jobless benefit claims swell.
Inflation and the Greenback
Unfortunately, as the central bank continues its aggressive rate-cutting campaign, inflation is taking root. Consumer price inflation was 4.1% in 2007, its highest annual rate in 17 years. The producer price index rose 7.4%, its biggest jump since 1981.
There has been no improvement so far in the New Year either. Yesterday (Tuesday), the Labor Department’s Producer Price Index (PPI), which measures inflationary pressures before they reach the consumer, rose 0.3% in February. That increase follows a 1% increase in January. Core inflation rose 0.5% for the month, the largest gain since November 2006. In January, core prices rose 0.4%.
Consumer prices rose 0.4% in January, while import prices increased 1.7%. The Consumer Price Index (CPI) and import-prices data for February has yet to be released, but it’s unlikely inflation has gone down, as the U.S. dollar has been in a freefall for the past year.
Because of the growing U.S. reliance on imports that range from crude oil and other commodities to sophisticated consumer electronics, the plummeting dollar can be highly inflationary. When the greenback declines against other currencies, the dollar doesn’t stretch as far when buying products priced in euro, yen or other currencies. That’s tantamount to a hefty – and escalating – price increase.
And there’s no sign that the dollar’s decline is going to end anytime, soon, especially if interest rates are going to continue to decline.
The euro has struck a series of record highs against the greenback in just the past few weeks, culminating at a value of 1.5905 dollars Monday. Since the Fed began cutting rates in mid-September, the dollar has lost 15% to the euro’s advances and 14% against the yen. Last Thursday, the dollar fell below the 100-yen level for the first time since October 1995.
“The momentum is definitely downward for the dollar,” Daisaku Ueno, senior economist at Nomura Securities (NMR), told the Associated Press. “With momentum going like this, no one knows where it will stop.”
Until yesterday, Bernanke had routinely offered his assurances that inflationary pressures remain “well anchored.” But in the face of oil at $110 a barrel – a price that’s expected to go much higher.
“Inflation has been elevated, and some indicators of inflation expectations have risen,” Bernanke said. [For insight on soaring oil prices – and profit plays you can make – read this recent Money Morning investment research report that predicts oil will hit $187 a barrel].
News and Related Story Notes:
- Bloomberg News: Dollar Gains Most Since 1999 Versus Yen as Fed Cuts 0.75 Point.
- Bloomberg: Fed Cuts Main Rate to 2.25%, Says Outlook `Weakened'
- Money Morning Special Investment Research Report: Three Ways to Play Money Morning’s Prediction That Oil Prices Will Reach $187 a Barrel.
About the Author
Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning at Money Map Press.