By Paul R. La Monica
CNNMoney.com editor at large
August 17 2007: 10:53 AM EDTNEW YORK (CNNMoney.com) --
The Federal Reserve, reacting to concerns about the subprime lending crisis that's rocked financial markets in recent weeks, Friday cut its so-called discount rate half a percentage point, to 5.75 percent.
The discount rate, the rate the Federal Reserve charges qualified lenders, mainly banks, for temporary loans, is largely symbolic. The central bank did not change its more closely watched federal funds rate, which affects credit cards, home equity lines of credit, car loans and other consumer loan rates. That rate remains at 5.25 percent.
But one economist suggested that the Fed's discount rate cut has more than token significance. David Wyss, chief economist with Standard & Poor's, said the cut could help convince banks it was okay to keep lending to companies or consumers that actually are creditworthy.
"This is an important move. It's not just a symbolic action. The Fed is telling banks that the discount window is open. Take what you need," Wyss said.
Wall Street cheered the cut. The Dow Jones industrial average surged 300 points at the open but later slipped back. The 30-share Dow was up about 90 points, or 0.7 percent, some 90 minutes into the session.
What the smart money's saying about the market The S&P 500 and the Nasdaq composite posted slightly bigger gains. Stock futures were trading lower before the open after another wild day Thursday but surged following the Fed's announcement.
"The Fed is trying to maintain some stability in the market. They can't control the financial markets, which are being driven by emotion right now. But this move was a good option that will bring some relief to the market," said Oscar Gonzalez, an economist with John Hancock Financial Services.
The Fed last met Aug. 7 and decided to leave both the federal funds and discount rates unchanged. But since then, stocks have plunged further due to fears that some financial institutions and hedge funds were in serious trouble because of the mortgage meltdown.
Mortgage lender Countrywide Financial <http://money.cnn.com/quote/quote.html?symb=CFC&source=story_quote_link> (Charts <http://money.cnn.com/quote/chart/chart.html?symb=CFC&source=story_charts_link>, Fortune 500 <http://money.cnn.com/magazines/fortune/fortune500/2007/snapshots/372.html?source=story_f500_link>), for example, announced Thursday that it needed to tap an $11.5 billion line of credit because of liquidity problems. That came a day after an analyst at Merrill Lynch suggested that Countrywide might need to declare bankruptcy.
"The credit crunch is both real and driven by fear but primarily fear. Nobody knows who is exposed to these subprime loans. Uncertainty is the problem," said Zach Pandl, an economist with Lehman Brothers.
With this in mind, several market observers felt that Fed chairman Ben Bernanke needed to acknowledge the risk that the subprime mortgage crisis could hurt the broader economy.
Read the Fed's statement In a statement, the Fed said it took the move to "promote the restoration of orderly conditions in financial markets."In another statement, the central bank indicated that "financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward."
The Fed added that "although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably" and that the Fed was prepared to take more action if necessary.
The Fed, as well as other central banks around the world, had responded to the market turmoil by pumping more cash in to the banking system over the past week.
But many market observers felt the Fed would also need to lower rates to restore investor confidence, citing the example of former Fed chair Alan Greenspan.
Under Greenspan's stewardship, the Fed cut rates at an emergency meeting in 1998 as a result of the Asian financial crisis and also lowered rates at two unplanned meetings in early 2001 due to an economic slump and again that year after the Sept. 11 terrorist attacks.
Your best moves in a crazy market While Greenspan was praised at the time for these rate cuts, some have since criticized him for helping to create a low interest-rate environment that fostered a culture of "easy money" where consumers who had poor credit histories were able to take out the types of exotic mortgage loans that are now defaulting.
As such, some may accuse Bernanke and the Fed of cutting rates in order to bail out consumers who took out loans that they never should have in the first place and the banks that made the loans and invested in them. Wyss did not buy this though.
"If you enjoy cutting off your nose every time you have a cold, then not cutting rates would be a good strategy .There a lot of people who have this puritanical view that everyone should be punished," he quipped. "But the Fed's job is to worry about the whole economy. It has to make sure that rest of the economy doesn't suffer. What the Fed did today has nothing to do with bailing out banks. If you were going to lose money on a bad mortgage you will still lose money."
With that in mind, the central bank's next scheduled meeting is Sept. 18. According to federal funds futures listed on the Chicago Board of Trade, investors are betting that it is all but certain the Fed will cut the federal funds rate by at least a quarter of a percentage point.
Lehman's Pandl expects a quarter-point rate cut in September and another one after the Fed's two-day meeting in late October. That would bring the fed funds rate down to 4.75 percent.
But Pandl does not think the Fed will need to act before September since Friday's move may be enough to reassure Wall Street that it has things under control.
