Shred the Fed

The Fed cut the federal-funds rate by 1/4 point to 4.25% for the third consecutive meeting yesterday, citing increased "uncertainty" about growth and inflation. (The central bank also reduced the discount rate it charges banks for direct loans by a 1/4 point to 4.75%). The central bank dropped its previous assertion that growth and inflation risks were balanced and pledged to "act as needed" to keep the economy growing and inflation in check.

Within moments, the question shifted to: did the central bank do enough? Investors voted a resounding “no” and sold stocks broadly. The issue at hand is that without significant Fed intervention, many believe that tight financial conditions faced by corporate and individual borrowers will be exacerbated and as a result, the economy will tip into recession. That fear put a halt to the December rally, which prior to yesterday’s action, saw the Dow rise by 2.7%. The Dow Jones Industrial Average plunged 294.26, or 2.1%, to 13,432.77%; the S&P 500 sank 38.31, or 2.5%, to 1,477.65; and the Nasdaq Composite Index sagged 66.6, or 2.5%, to 2,652.35.

Within moments, the talking heads were bashing the bankers, but interestingly, the anti-Fed diatribes were flying even before the decision. Superstar investor/financier George Soros told the Wall Street Journal that “There’s no question that the Fed was remiss in the way they handled this [the sub-prime/credit crisis]. They are guided by a theory of the market which I think is false. The idea is that markets actually reflect reality and so you should really rely on the markets. And in fact, with all these new instruments it’s very difficult to calculate risk.”

I think that Soros probably is right in that the Fed needs to kick up its rate cuts, but before the decision, the expectation for a ½ point was running at only 38%, so what explains the big sell-off? Let’s back up and remember where we came from three weeks ago. On November 26th, stocks dropped to a level that qualified for a classic 10% correction from the top. Since that time, stocks started to rally as a couple of Fed officials, including the chairman himself, put December rate cuts back on the table. Once the decision was official, some investors worried that they had gotten a little ahead of themselves.

What now? Investors will likely continue to vacillate between excitement over future rate cuts (after yesterday’s decision, futures markets were pricing in a 94% probability of a ¼ point cut at the January meeting) and panic over a looming recession. The result will likely fall somewhere between the two, but getting there is sure going to be bumpy.