Updated from 3:39 p.m. EST
threw the market a curveball Wednesday, cutting interest rates by a larger-than-expected 50 basis points and shifting its policy bias to neutral.
Investors already had been surprised twice Wednesday by a Republican sweep of Congress and by news of SEC Chairman Harvey Pitt's resignation. The decision to cut rates by half a point served as yet another unforeseen event for investors to digest. Traders had priced in a 15% chance of a cut this size and a 100% chance of a quarter-point cut.
Stocks, which had been trading flat prior to the announcement, popped up initially on the news, then quickly sank back, before recovering to trade higher again.
"Regardless of the 50-point move, stocks have come a long way in the last four weeks, and with the Fed on the sidelines for a while I think the market's going to take a couple of days to digest its gains," said Joe Liro, equity strategist at Stone & McCarthy Research.
Dow Jones Industrial Average
closed up 93 points, or 1.1%, at 8771, while the
gained 18 points, or 1.3%, to 1419. The
added 8 points, or 0.9%, to 923.
The central bank's move, which is the 12th since January 2001 and the first since last December, takes the Fed-funds rate down to 1.25%. The Fed also approved a 50 basis-point reduction in the discount rate to 0.75%.
"Incoming economic data have tended to confirm that greater uncertainty, in part attributable to heightened geopolitical risks, is currently inhibiting spending, production, and employment," the Fed said in its policy statement. "In these circumstances, the Committee believes that today's additional monetary easing should prove helpful as the economy works its way through this current soft spot."
But the Fed added that the risks between inflation and economic growth are now balanced, suggesting that additional rate cuts may not be forthcoming any time soon.
Bob Gay, global head of fixed income and economist for Commerzbank Securities, said the Fed's move was aggressive, and shows that it is trying to reassert itself as being ahead of the curve. But what was particularly shrewd, he said, is the way the Fed delivered the news. "They couched it in exactly the right terms," he said, noting that the central bank cited geopolitical risks and general uncertainty, rather than blaming fears of deflation or concerns about the economy heading into 2004.
In changing the policy to neutral, "they're basically saying this move will work. This is not Japan; they will be right. The only issue is when," Gay said.
Josh Feinman, chief economist at Deutsche Bank, agreed about the Fed's rhetoric. "It just thinks we're going through a rough patch, but that monetary policy is very accommodative and that the recovery is not in danger," he said.
Economists had widely expected a quarter-point cut, saying that no rate cut could have suggested the Fed wasn't doing enough to spur the nascent economic recovery. A larger move, on the other hand, could have spooked the market by hinting at more serious economic weakness. The central bank appeared to address this concern with its policy statement, however.
"This serves as a pre-emptive action, but at the same time it does not suggest that policy makers are in a state of panic," said Lynn Reaser, chief economist and senior market strategist at Banc of America. Reaser feels the economic data are somewhat stronger than the Fed believes, but she said she approved of the move Wednesday, which she called an "aggressive insurance policy."
In recent weeks, the odds of a quarter-point rate cut had increased, as data showed the economy is not recovering as quickly as expected. The jobs report on Friday showed an uptick in the unemployment rate, and the manufacturing sector has been contracting for the past three months. Meanwhile, consumer confidence is sitting at a nine-year low.
Unless the economy sees "further shocks" in the months ahead, rates may have reached a low, according to some economists. "But if the economy weakens further or a war with Iraq leads to an oil shock, the Fed will certainly be willing to ease further," said Bruce Steinberg, chief economist at Merrill Lynch.
Steinberg added that the real Fed-funds rate, which takes inflation into account, is now -0.5%, using the chain-weight core CPI. "The latest move is no panacea. But lower rates reduce debt service for both the corporate and household sectors," he said.