Stocks in Europe and the USA rallied on the news.
"The statement is having the desired immediate effect of boosting the stock market ... and is designed to get credit markets to re-engage in bidding for higher risk assets," said Stuart Hoffman of PNC Bank.
A statement accompanying the discount rate announcement also appeared to increase the chance of a cut in the more important federal funds rate. The Fed has held its target for the fed funds rate at 5.25% for more than a year.
Since hitting a record close of 14,000.41 a month ago, the Dow Jones industrial average had shed 1,154.63 points in a string of triple-digit losing days that raised anxiety levels not just on Wall Street but also on Main Street.
The markets have been pummeled by a rapidly spreading credit crisis that began with rising defaults in subprime mortgages — home loans made to people with weak credit histories. Now the problems are spreading to other borrowers.
The Fed, which had already pumped billions of dollars of liquidity into the financial system over the past week, also said Friday that it would extend the terms of its discount loans, which must be backed by sound collateral, to 30 days from overnight. And borrowers can renew the loans.
The move, which cuts the discount rate to 5.75% from 6.25%, is designed to ease a credit crunch in financial markets by giving banks access to somewhat longer-term financing if they can't borrow anywhere else.
The Fed is clearly trying to make the discount rate a more attractive option for borrowers by extending the terms of the loans to up to 30 days or more, and cutting the interest rate.
The Fed explicitly noted that sound home mortgages can be used as collateral for the discount loans. That could be designed to give more lenders confidence to approve mortgages, including so-called jumbo loans over $417,000, for which the secondary, or resale, market has largely dried up.
But market analysts caution that the move is not as far-reaching as a cut in the federal funds rate, the key interest rate that the Fed uses to manage the economy. The Fed has held its target for that rate at 5.25% for more than a year. The central bank pumped billions of dollars into the financial system the past week to keep the rate at that level and make sure banks could meet cash demands. But that hasn't staunched the market bleeding.
"Unlike the Fed funds rate — which affects all banks' cost of funds — a discount rate cut only lowers the cost of emergency borrowing by institutions in distress," said Carl Weinberg of High Frequency Economics.
"However, we believe that the Fed's action and statement today raise the odds of a reduction in the Fed funds rate at the September FOMC meeting, or perhaps even before," he said.
"Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward," the Fed said Friday, in language that makes a future rate cut more likely.
"In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the (Fed) judges that the downside risks to growth have increased appreciably," the central bank said.
The Fed said it would continue to monitor the situation and act as needed to mitigate adverse effects on the economy. It emphasized that it would stay engaged until market conditions "improve materially."
The discount rate is applied to loans the Fed makes directly to banks, while the federal funds rate covers loans that banks make to each other on a short-term basis. As a result, the fed funds rate is much more critical in determining interest rates in the economy, such as banks' prime lending rate, the base rate for many consumer and business loans.
"At the risk of lifting the wizard's curtain and ruining this gesture, I need to point out that a cut in the discount rate is not an ease," Stephen Stanley of RBS Greenwich Capital said in an advisory to clients, pointing out that borrowing through the Fed's discount window was minimal through Wednesday.
"This should be thought of as another (indeed, probably the last) intermediate step short of an ease" in the fed funds rate, Stanley said.
The Fed's policymaking Open Market Committee held a rare gathering Thursday — its next, regularly scheduled meeting is Sept. 18 — to debate Friday's move. Some of the Fed Board of Governors participated in person and other regional Federal Reserve bank presidents participated remotely. The vote was unanimous, though Dallas Fed President Richard Fisher voted as an alternate to St. Louis Fed president William Poole.
The nation's once high-flying housing market is sinking deeper into gloom, and credit, the lifeblood of the economy, is drying up. A growing number of economists believe these problems, including declining consumer confidence, could lead to a recession.
Contributing: Associated Press
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