Fed’s latest cuts spark stock rally

The Federal Reserve, fully embracing its role as rescuer of financial markets and the economy, slashed interest rates again Tuesday even as it conceded that a traditional target of its efforts, inflation, was picking up.

Although the move to cut two key rates by three-quarters of a percentage point fell short of the full-point reduction many on Wall Street had expected, the stock market responded with a huge rally.

The Dow Jones industrial average ended the day up 420 points, or 3.5%, with much of the gain coming after the Fed announced its decision less than two hours before the end of trading. The broader Standard & Poor’s 500 stock index surged more than 4%.

The central bank cut its federal funds rate -- the rate banks charge one another for overnight loans -- to 2.25%. The move is designed to lower interest rates across the board in a bid to ease the credit crunch and slow or reverse the economy’s slide into recession.

Major banks responded by cutting the prime rate, used to set rates on many consumer and business loans, to 5.25% from 6%.

The Fed also Tuesday sliced the discount rate that it charges for direct loans to banks. On Sunday, in an effort to break the back of the credit freeze, the Fed said the country’s biggest investment houses could also borrow at the discount rate, which now stands at 2.5%.

“The cuts show they recognize there’s almost a lust for panic going on in the financial markets, and the only way to stop it is to make sure there is liquidity available, no matter what,” said Roger M. Kubarych, a former senior official at the Federal Reserve Bank of New York and now chief economist at UniCredit Global Research. “They’ve become the liquefier of last resort.”

As evidence of how far the Fed has departed from maintaining stable prices -- a major Fed goal along with maximum employment -- central bank policymakers acknowledged in a statement Tuesday that “inflation has been elevated, and some indicators of inflation expectations have risen.”

Previously, Fed officials had said that one of the few things about the economy that had remained in bounds was “inflation expectations” -- how much people expect prices to rise. Elevated price expectations are a particular concern because they can become a self-fulfilling prophecy.

At any other time, a finding of higher inflation expectations would all but guarantee that the Fed would raise interest rates. Lower rates tend to feed inflation, while higher rates restrain it.

In another indication of the Fed’s shift in strategy, two members of its main policy committee -- Richard W. Fisher and Charles I. Plosser, presidents of the Fed banks of Dallas and Philadephia, respectively -- opposed Tuesday’s cut in the federal funds rate, saying it was too big. The committee’s decisions are typically unanimous.

In addition, with the reduction in the discount rate, the Fed is allowing banks and key financial firms to borrow at virtually no cost -- because the interest rate is well below the inflation rate. As measured by the Fed’s preferred inflation gauge, prices rose at a 3.9% annual clip in the final quarter of last year.

In its statement, the Fed justified its actions by painting a dark picture of the economy’s immediate prospects.

“The outlook for economic activity has weakened further,” the statement says. “Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.”

About the most hopeful thing the Fed had to say was that it expected prices of energy and other commodities to level off, but that’s apparently because it expected the economy to slip into recession, causing demand for those goods to slacken.

As recently as last summer, Fed officials were unconcerned about problems in the nation’s sub-prime mortgage market, in which home loans had been made to people with sketchy credit and then bundled into securities that were sold to investors. Officials publicly doubted that rising defaults among sub-prime borrowers would have any effect on the rest of the mortgage market, much less the entire financial system and broader economy.

But the defaults sowed doubts about the value of the sub-prime securities, and those doubts eventually spread to a whole generation of similar asset-backed financial instruments that became popular at the same time.

As evidence mounted that the problem was spreading, central bank policymakers approved a few moderate rate cuts in late summer and early fall. But it was not until December that they began to realize the magnitude of the danger.

Since last August, the Fed has slashed the funds rate from 5.25% to 2.25%, and the discount rate from 6.25% to 2.5%. But the cuts didn’t have the effect the Fed expected because in many cases banks weren’t cutting their rates on mortgages, credit card debt and business loans.

In a series of maneuvers not employed since the Great Depression, the Fed sought to outflank the banks by agreeing to make various types of loans to its so-called primary dealers, the giant investment firms through which the Fed conducts business.

The latest step came Sunday when the central bank said it would make direct short-term loans to the firms for at least the next six months.

In effect, said Kubarych, the former New York Fed official, “They’ve decided to treat the primary dealers as if they were full-fledged members of the Federal Reserve System.”

The Fed’s move to expand its assistance beyond banks to nonbank financial firms is more than happenstance. Over the last quarter-century, the fraction of Americans’ financial needs filled by these firms has ballooned, leaving the Fed with substantial influence over only commercial banks, a segment that had been shrinking.

“Basically, the Fed has lost control over the safety and soundness of the financial system and is trying to get it back,” said Kubarych. “It’s no longer good enough just to cut the fed funds rate. You’ve got to offer facilities to liquefy illiquid securities” like the new mortgage-backed securities at the center of the current crisis.

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peter.gosselin@latimes.com

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Federal Reserve’s statement

Here is the text from the Associated Press of the Federal Reserve’s statement Tuesday on interest rates:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points [three-quarters of a percentage point] to 2.25%.

Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

Inflation has been elevated, and some indicators of inflation expectations have risen. The committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The committee will act in a timely manner as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were Ben S. Bernanke, chairman; Timothy F. Geithner, vice chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Gary H. Stern; and Kevin M. Warsh. Voting against were Richard W. Fisher and Charles I. Plosser, who preferred less aggressive action at this meeting.

In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate, to 2.5%. . . . The board approved the requests submitted by the boards of directors of the Federal Reserve banks of Boston, New York and San Francisco.