The Federal Reserve dramatically intervened today to fend off what many feared would be a bloody sell-off on Wall Street following a painful slump in world markets over the holiday weekend.
With an interest rate cut that surprised markets in both its size and timing, the Fed acknowledged that worries over near-term economic growth are growing more severe by the day.
Central bankers lowered the benchmark fed funds rate by three quarters of a percentage point to 3.5 percent while warning the economic outlook is "weakening" amid increasing risks to future growth. The move—the largest cut since October 1984—aligns the Fed more closely with both Wall Street and Main Street in concerns that the U.S. economy may be falling into a recession.
For stocks, the Fed's decisive move may have stanched the heaviest selling expected by traders after a huge drop in world markets on Monday, when Wall Street was closed for the Martin Luther King Jr. holiday.
By midday the Dow recovered notably, down 107 points, or 0.89 percent, after a brutal 464-point drop at the open.
"It's a little late, but it certainly helps," says Nick Raich, director of research at National City Corp. "If the Fed didn't step in today, it could've been brutal. It could have been a 1,000-point drop in the Dow."
The Fed's newly aggressive plan to inject liquidity into the markets via lower interest rates is expected to continue. Fed fund futures now predict another cut of half a percentage point when Fed Chairman Ben Bernanke and other policymakers meet on January 29 and 30.
Markets may need all the help they can get, as little good news appears to be forthcoming from the economy or corporate America. Fourth-quarter earnings are just getting started, but they have been broadly dismal so far. Both Bank of America and Wachovia announced poor results today, though financial shares were in positive territory. Quarterly results will most likely drive stocks over the coming weeks, and current estimates see a 15 percent to 20 percent decline from a year ago. Meanwhile, both unemployment and inflation continue to edge up.
Timed as it was following large declines in markets from Hong Kong to Britain over the weekend, the move also brings into focus both the Fed's motivation for shoring up the economy and possible limitations to its ability to revive ailing credit and equity markets.
Critics say the Fed's decision to react in the face of market trouble marks a trade-off with respect to its stated goal of fighting inflation. With consumer prices running well above the Fed's unofficial comfort zone, further rate cuts to shore up near-term economic weakness give price pressures room to percolate, especially given ongoing increases in costs for energy and food. The Fed appears to be betting a slowing economy will contain price pressures. Other analysts aren't so sure.
"These cuts have done absolutely nothing except spur inflation and weaken the dollar. So I think people are being a little too dependent and faithful in the Fed's ability to cure what ails us," says Peter Boockvar, equity strategist with Miller Tabak. He points out that if the Fed is trying to prop up stocks, it's doing a poor job. The S&P 500 is well below its September 18 close, the day the Fed slashed rates by half a percentage point in its first response to the credit crisis.
In its statement, the Fed warned that while some parts of credit markets have improved, tight lending conditions still hamper some businesses and consumers at a time when unemployment is on the rise and the battered housing market shows no sign of hitting bottom. Slashing rates hints that Fed officials are more concerned about the U.S. economy sliding into a nasty recession than previously thought, given Bernanke's reluctance to use the "R" word in recent testimony and speeches.
From Washington and the campaign trail, presidential hopefuls varyingly deemed the economy in "a global economic crisis" (Hillary Clinton) or in a manageable downturn where with "the right leadership and pro-growth policies the economy can weather this upheaval" (John McCain). Mitt Romney, the most Wall Street savvy contender in the race, called it a "buying opportunity" because "my experience has always been what goes down comes back up."