Fed Cuts Key Rates by 0.25%; Markets Rally

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Includes: AGG, DIA, SPY
by: SA Eli Hoffmann

The Federal Reserve announced Wednesday its has lowered its fed-funds target rate 0.25% to 4.5%, coupled with a 0.25% cut to the discount rate, bringing it to 5%. "Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time," it said.

The rate cut had been widely predicted among economists: "In an economic expansion that had already slowed, leading sectors continue to display surprising softness and further cautious policy action can help to contain a widening out of the damage," Citigroup economist Robert DiClemente wrote recently. But data released earlier Wednesday showed economic growth was stronger than economists had expected; Q3 U.S. GDP growth rose to 3.9% annually, its fastest rate since the beginning of 2006, and far faster than the 3.0% economists predicted (full story). Also, ADP Employer Services said Wednesday U.S. private employers added 106,000 jobs in October, well above analyst expectations of a 60,000 job gain. "Right now, I'd say chances of a cut in next meeting in December are smaller than they were two days ago, largely because of the strong numbers that are coming in with GDP," Finance professor Steve Wyatt said.

In a nod to continuing inflationary concerns, the Fed said: "Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully. The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth." The statement was seen as leaving open the option for no further rate drops, or a potential rake hike down the road: "They've got to leave it open on both sides and see how the economy moves along," said Thornburg Investment's Thomas Garcia before the rate drop. "They definitely have to have language that says, 'If we start to see inflation pick up, we can still raise rates.'"

Nine of the ten FOMC Governors voted for the rate drop; the sole dissenting voice was that of Kansas City Fed Governor Thomas M. Hoenig, who preferred no change in the fed funds rate. "It was interesting that Hoenig dissented," Putnam's Michael Atkin noted. "The first dissent we have had in a long time, in favor of no change. The language of the text is perhaps a little bit more hawkish on inflation than people had expected."

Treasury markets were sharply down on the news. After an initial move to the downside, stock markets rallied. Gold futures breached the $800 mark, as many predicted. "Really nothing startling at all, and no surprises," Oppenheimer's chief investment strategist Michael Metz told investors following the announcement. "To me it validates the view that we've embarked on an easing policy that will extend as far as the eye can see."

Immediately following the news, Wachovia announced it was lowering its prime lending rate from 7.75% to 7.5%.

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