Fed cuts discount rate half a point, stocks rally

WASHINGTON -- The Federal Reserve early Friday announced a surprise half-percentage-point cut in the discount rate — what it charges banks for short-term loans — saying deteriorating market conditions threaten economic growth.

Stocks in Europe and the USA rallied on the news.

"The statement is having the desired immediate effect of boosting the stock market ... and is designed to get credit markets to re-engage in bidding for higher risk assets," said Stuart Hoffman of PNC Bank.

A statement accompanying the discount rate announcement also appeared to increase the chance of a cut in the more important federal funds rate. The Fed has held its target for the fed funds rate at 5.25% for more than a year. The Fed has held its target for the fed funds rate, the central bank's main tool for managing the economy, at 5.25% for more than a year — including an August 7 meeting at which it called inflation the predominant threat to the economy.

Since hitting a record close of 14,000.41 a month ago, the Dow Jones industrial average had shed 1,154.63 points in a string of triple-digit losing days that raised anxiety levels not just on Wall Street but also on Main Street.

The markets have been pummeled by a rapidly spreading credit crisis that began with rising defaults in subprime mortgages — home loans made to people with weak credit histories. The problems have disrupted a slew of financial deals and have made it tougher for people with good credit to get mortgage loans, further deepening an already steep housing recession.

Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward," the Fed said Friday, in language that indicates a future rate cut is more likely.

"In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the (Fed) judges that the downside risks to growth have increased appreciably," the central bank said.

The Fed said it would continue to monitor the situation and act as needed to mitigate adverse effects on the economy. It emphasized that it would stay engaged until market conditions "improve materially." Unlike its August 7 statement, the Friday Fed language did not mention inflation.

The Fed had already pumped tens of billions of dollars of liquidity into the financial system over the past week in an effort to calm the markets and ease a credit crunch. Moody's Economy.com in an analysis said those efforts may not have successfully gotten cash to overseas lenders or smaller banks. Using the discount window would give more types of lenders more direct access to Fed assistance, and allow them to use a broader arry of collateral.

"A liquidity crunch still exists for mortgage lenders and asset-backed commercial paper. Liquidity did not seep through to the broader financial markets because the primary (securities) dealers the Fed deals with are holding on to the cash the Fed has pumped in, Zoltan Pozsar of Economy.com wrote in an analysis.

The Fed is trying to make the discount rate more attractive by extending the terms of the loans to up to 30 days or more, and cutting the interest rate to 5.75% from 6.25%. Borrowers could also extend the loans. The Fed explicitly noted that sound home mortgages can be used as collateral for the discount loans. That could be designed to give more lenders confidence to approve mortgages, including so-called jumbo loans over $417,000, for which the secondary, or resale, market has largely dried up.

Despite a Fed statement last week reminding the markets last week that the discount window was available, lenders have largely stayed away.

Market analysts cautioned that the move is not as far-reaching as a cut in the federal funds rate. The Fed has held its target for that rate at 5.25% for more than a year. The central bank pumped billions of dollars into the financial system the past week to keep the rate at that level and make sure banks could meet cash demands. But that hasn't staunched the market bleeding.

"Unlike the Fed funds rate — which affects all banks' cost of funds — a discount rate cut only lowers the cost of emergency borrowing by institutions in distress," said Carl Weinberg of High Frequency Economics.

"However, we believe that the Fed's action and statement today raise the odds of a reduction in the Fed funds rate at the September FOMC meeting, or perhaps even before," he said.

The discount rate is applied to loans the Fed makes directly to banks, while the federal funds rate covers loans that banks make to each other on a short-term basis. As a result, the fed funds rate is much more critical in determining interest rates in the economy, such as banks' prime lending rate, the base rate for many consumer and business loans.

"At the risk of lifting the wizard's curtain and ruining this gesture, I need to point out that a cut in the discount rate is not an ease," Stephen Stanley of RBS Greenwich Capital said in an advisory to clients, pointing out that borrowing through the Fed's discount window was minimal through Wednesday.

"This should be thought of as another (indeed, probably the last) intermediate step short of an ease" in the fed funds rate, Stanley said.

The Fed's policymaking Open Market Committee held a rare gathering Thursday — its next, regularly scheduled meeting is Sept. 18 — to debate Friday's move. Some of the Fed Board of Governors participated in person and other regional Federal Reserve bank presidents participated remotely. The vote was unanimous, though Dallas Fed President Richard Fisher voted as an alternate to St. Louis Fed president William Poole.

The nation's once high-flying housing market is sinking deeper into gloom, and credit, the lifeblood of the economy, is drying up. While a growing number of economists believe these problems, including declining consumer confidence, could lead to a recession many still expect, like the Fed, that the economy will continue to grow at a moderate pace.