Fed's cut in discount rate encourages market, raises Bernanke's rep with investors

~ A cut in the more important federal funds rate is expected to follow in short order.

WASHINGTON -- A dramatic cut in the Federal Reserve's discount rate sent stocks soaring Friday, but the spreading global credit crisis means the Fed will almost certainly have to do more.

A cut in the more important federal funds rate is expected to follow in short order as the central bank battles to keep the economy out of recession. Some economists believe the Fed could engineer more interest rate reductions at each of its three remaining meetings this year.

With his surprise announcement before Wall Street opened for trading on Friday, Federal Reserve chairman Ben Bernanke, a former Princeton professor, went from being a "C" student in the eyes of investors to earning an "A-plus."

The Dow Jones industrial average shot up more than 300 points right after the opening bell and held on to most of the gains to finish the day up 233.08 at 13,079.08.

Bernanke found a clever way to give banks access to badly needed funds by cutting the discount by a half-point to 5.75 percent. That is the interest rate the Fed charges banks for direct loans.

Stepping up lending

The Fed's action was seen as a way to prod banks to step up their short-term lending in the face of a near paralysis in many debt markets. The current credit crisis began with rising defaults on subprime mortgages, loans made to borrowers with weak credit.

It marked the Fed's first change in rates between regularly scheduled meetings since Sept. 17, 2001, when the central bank was struggling to get financial markets back into operation after the terrorist attacks on the World Trade Center.

Even more important than what the Fed did on Friday was what it said.

In a brief statement, Bernanke and his colleagues on the Federal Open Market Committee said they judged that "the downside risks to growth have increased appreciably" and they were "prepared to act as needed to mitigate the adverse effects on the economy arising from disruptions in financial markets."

That statement was seen as a clear signal that the Fed had moved its "bias" -- which signals the next direction for interest rates -- from seeing inflation as the biggest economic threat to concern about weak growth. Fed worries about inflation mean possible interest rate increases, while worries about growth mean possible rate cuts.

The new wording marked a significant shift from just 10 days ago. At the Fed's last meeting on Aug. 7, it held interest rates unchanged and repeated the view that it still believed the predominant risk to the economy was that inflation would not slow as expected.

That statement produced dismay in financial markets as investors worried that Bernanke, the academic, was proving less adept than his predecessor, Alan Greenspan, at responding quickly to the first signs of market distress.

Greenspan began building his legend with his quick response to the Black Monday stock market meltdown in October 1987, which occurred just two months after he took over as Fed chairman. Greenspan moved to insulate the economy from that severe episode of stock market turbulence.

Bernanke's actions since Aug. 7 have helped him rebound from what was seen as an initial stumble. Since last Thursday, the Fed has pumped billions of dollars into the banking system in daily infusions to make sure banks have sufficient reserves to respond to borrowing demands from creditors who found their normal sources of money drying up.

Then with Friday's cut in the discount rate and the statement signaling the Fed was contemplating cuts in the funds rate, the impression of Bernanke's crisis-management skills improved further.

"The Fed was behind the curve in dealing with this crisis before today. Now they are even with the curve," said David Jones, chief economist at DMJ Advisers, an economic consulting firm. "They now have a better chance of mitigating the damage from an all-out global credit crisis."

The thinking now is that the current credit crisis could establish Bernanke's reputation just as Black Monday did for Greenspan two decades ago. But a lot will depend on whether the Fed will act forcefully enough to instill confidence and keep the economy out of a recession.

"There was a lot of fear and panic out there. Investors were looking for someone to lead and that is what the Fed did today," said Lyle Gramley, a former Fed board member and now senior economic adviser at Schwab Washington Research Group.

But Gramley said he still put the possibility of a recession at about 50-50 as the credit crisis adds to earlier problems stemming from a serious slump in housing that has dragged down consumer confidence.

One worrisome sign on that front was the report Friday that the University of Michigan's consumer confidence survey for early August fell from 90.4 in July to 83.3 in early August, the lowest point in a year, a drop blamed in part on the recent market turmoil.

If people grow more concerned, they could cut back on their spending, which would be a serious jolt since consumer spending accounts for two-thirds of economic activity.

Friday's move to cut the discount rate will not have an impact on consumer interest rates in the way that cutting the federal funds rate triggers an immediate drop in banks' prime lending rate, the benchmark for millions of consumer and business loans.

However, Friday's move will allow banks to deal with the severe credit crunch by making it easier for them to make loans to businesses.

With the housing market sinking deeper into gloom and credit to businesses drying up, analysts have been slashing their forecasts for growth, as measured by the gross domestic product, for the second half of this year.

Mark Zandi, chief economist at Moody's Economy.com, believes the 3.4 percent GDP growth rate of the April-June quarter will slow to 2 percent or even less in the final six months of the year, but that the country will be able to avoid a recession as long as the Fed continues to keep on top of market developments.

"While Bernanke started out the class weakly, he is catching up fast," Zandi said. "The final exam hasn't been taken yet, but at the moment, it looks like he will do well."