U.S. equity markets were up strongly Wednesday after Fed Vice Chairman Donald L. Kohn rekindled investor hopes for interest rate cuts, sending the Dow Jones Industrial Average soared 335 points (2.59%) to close at 13,293.
Kohn said some of the economy's improvement has unraveled over the past few weeks amid renewed economic turbulence. He reiterated the need for "nimble" Fed policy in order to address economic risks. "The increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October," Kohn told the Council on Foreign Relations.
"Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses," he said. The statement comes in contrast to those of other Fed officials, who over recent weeks have signalled they are generally satisfied with present interest-rate levels in view of the present economic outlook.
"Now you have Kohn pointing out the Fed can take action to offset what is happening in the financial markets; it does suggest the Fed is being responsive and is not just focused on inflation," said LPL Financial strategist Jeffrey Kleintop.
Kohn blamed the upheaval largely on housing and mortgage market woes. "Expectations of ever-rising house prices along with increasingly lax lending standards, especially on subprime mortgages, created an unsustainable dynamic, which is now reversing." What the Fed is watching closely, he said, is, "What is happening to credit for other uses, and how much restraint are financial market developments likely to exert on demands outside the housing sector?" Namely, are concerns over mortgage-related losses "constricting the flow of credit to a broad range of borrowers?"
The vice chairman said that while reducing interest rates in the face of risk-induced crises may reduce the penalty incurred by those who exercised poor judgement, "we should not hold the economy hostage to teach a small segment of the population a lesson."
He concluded: "Uncertainties about the economic outlook are unusually high right now. In my view, these uncertainties require flexible and pragmatic policymaking... we will act as needed to foster both price stability and full employment," (full speech).
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