Bernanke Blinks and Wall Street Rallies

The Fed's move to cut the discount rate is the perfect elixir to stem growing panic over the credit crunch.

By + More

"Fed says 'no más,'" is how JPMorgan economist Bruce Kasman succinctly summed up the Federal Reserve's decision to cut the discount rate—the rate it charges banks on loans they receive from the Fed's so-called discount window—in his morning note to clients. And little wonder why: The whole global financial system seemed to be going a bit pear-shaped as the week ended. Even though Wall Street staged a late-day rally yesterday, Japan's benchmark Nikkei fell 5.4 percent overnight, its biggest drop in seven years.

The Fed move was a surprise, but its statement was even more so. Such a between-meetings statement is rare, and the language strongly hinted that the Fed will cut the federal funds rate in September. The Federal Reserve Open Market Committee noted: "Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth forward.... the downside risks to growth have increased appreciably." In fact, Wall Street is now pricing in a series of rate cuts that would bring the fed funds rate down as much as a full percentage point to 4.25 percent. A few more thoughts on the Fed's move and its fallout:

1) Back in the 1990s, Alan Greenspan and Robert Rubin were charter members of the so-called Committee to Save the World for their efforts to stem the Asian currency crisis. To curb America's mortgage credit crisis today, we have the informal Committee to Nudge Bernanke to Save the Economy. Its members include Larry Kudlow and Jim Cramer of CNBC, as well as economist Edward Yardeni. They've all been pushing hard for immediate Fed action.

2) In his 1999 book, Faster, journalist James Gleick wrote about the increasing pace of American life: instant coffee, instant replay, etc. The same goes for Wall Street. Technology, globalization, and financial innovation mean markets move at warp speed. An adjustment that once may have taken weeks or months may now play out in days—as we have just seen—and that acceleration can cause panic, which the Fed must be aware of. Sometimes leisurely monthlong policy deliberations aren't going to cut it. It's not flinching—it's facing reality.

3) In this post a couple of days ago, I speculated that the mortgage meltdown may be dooming GOP presidential hopes in 2008. The last thing the incumbent party wants is an economic slowdown as an election approaches.

But the underlying economy is strong—it probably grew at a greater-than-4-percent annual rate in the second quarter—and if the Fed plays this right, the economy might reaccelerate throughout 2008 despite the credit crunch. If so, this whole episode might end up looking like 1988, where the '87 market crash was an afterthought in the presidential election because the real economy kept chugging along. Despite the market crash, gross domestic product growth was 3.7 percent in 1987's third quarter, 7.2 percent in 1987's fourth quarter, 1.9 percent in 1988's first quarter, 5.2 percent in 1988's second quarter, and 2.2 percent in 1988's third quarter.