Financial Markets Cheer New Fed Move

Investors are heartened by the central bank's decision to add liquidity to ease the credit crunch.

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Stocks and credit markets responded with exuberance early today to the Federal Reserve's latest efforts to inject liquidity into the troubled financial system. The Fed's plan would make up to $200 billion of treasury securities available to primary dealers—banks and brokerages that trade directly with the Fed—for 28 days. At the same time, the central bank broadened the scope of collateral that borrowers can use to secure the loans to include federal agency debt and certain residential mortgage-backed securities. The Dow Jones industrial average soared more than 200 points on the news, as key credit spreads narrowed.

"The Fed is swapping treasury securities for less desirable collateral, and that is taking these securities off the books of banks and brokerages, at least for now," says Michael Englund, the chief economist at Action Economics. That's good news for banks and brokerages because "the treasury securities that they are getting are more easily tradable," Englund says.

The Fed's previous efforts to inject liquidity into the system have relied primarily on expanded access to funds by deposit-taking institutions but did not include financial intermediaries such as investment banks and securities firms, says David Resler, chief economist at Nomura Securities. But the Fed's new plan "widens the list of counterparties that can use Federal Reserve to help gain relief from the liquidity strains that have plagued the financial markets," Resler says. "I think this is maybe the most important thing they've done yet."

Michael Darda, the chief economist at MKM Partners, says the Fed's action shows that the central bank is willing to get more creative as it tries to resolve the credit crisis. "The point is that the Fed still has tools to employ aside from rate cuts, which we believe will come at an increasingly inflationary price," Darda said in a report. Still, Darda notes that markets are pricing in a significant probability that the Fed will reduce its benchmark interest rate by 75 basis points at its next meeting.