As is often the case, the rumor mill was wrong but included a kernel of truth.

Rather than an emergency, intermeeting fed fund rate cut, as was widely speculated Thursday, the Federal Reserve Friday cut its less heralded discount rate, the short-term rate at which the Fed lends to banks and other depository institutions, a more measured step initially applauded by Wall Street's frazzled denizens.

But the debate over whether the Fed needs to do more persists, and the stock market's initial embrace of the Fed action ( at least they're doing something) dissipated by midmorning.

Cutting the discount rate "appears to be Bernanke's attempt to thread the needle," writes Joseph Brusuelas, chief U.S. economist at IDEAglobal.

The needle that the Fed chairman and his cohorts are trying to thread is to craft a response to what is currently a financial markets (vs. "real economy") crisis without either reinflating the animal spirits that caused problems with leveraged bets in the first place or losing their inflation-fighting credentials.

By taking a tough line at its Aug. 7 policy meeting, despite high-profile problems at two Bear Stearns ( BSC) hedge funds and the implosion of mortgage lenders such as American Home Mortgage ( AHM), the Fed seemed to be turning a deaf ear to cries for relief. But rather than bailing out speculators, as some critics contend, the Fed on Friday was responding specifically to evidence of problems in the commercial paper market, typically obscure but crucial short-term debt.

This week saw companies such as Countrywide Financial ( CFC), KKR Financial Holdings ( KFN), Thornburg Mortgage ( TMA) and Canada's Coventree hit by problems accessing the commercial paper market , or speculation thereof.

Major corporations, from Citigroup ( C) to General Electric ( GE) on down, use commercial paper to finance their operations, and the Fed is rightfully concerned that problems in that market would have serious economic implications, should they persist. This possibility prompted the Fed to acknowledge in Friday's statement that "downside risks to growth have increased appreciably."

"The explicit inclusion of risk to growth ... due to turmoil in financial markets is the key aspect of the action by the Fed and suggests that the Fed is cultivating the markets for an aggressive rate cutting campaign should market conditions deteriorate further," writes Brusuelas.

Surely, the Fed gave itself wiggle room Friday to cut the fed funds rate, the short-term target rate at which banks lend to other banks -- room it didn't seem to have after St. Louis Fed President William Poole's comments Wednesday that the Fed should not ease unless there was a financial "calamity."

In addition to cutting the discount rate by 50 basis points to 5.75%, the Fed announced a change to the Reserve Banks' usual practices, to allow the provision of term financing for as long as 30 days instead of overnight. The changes will remain in place until the Fed determines that market liquidity "has improved materially," the statement reads.

Following steep overnight losses in international bourses -- including the Nikkei's worst one-day decline since the Sept. 11, 2001, terror attacks -- U.S. equity futures were pointing to a sharply lower open early Friday -- even scuttlebutt about a potential "crash." Futures quickly reversed following the Fed's discount rate cut at around 8:15 a.m. EDT, and major averages jumped in early trading. But after trading as high as 13,167.68 earlier, the Dow Jones Industrial Average was recently up 130 points to 12,976.

The S&P 500 and Nasdaq Composite were following similar patterns as traders continued to speculate about whether the central bank did too much, not enough or got it just right.

Rate Debate Continues

The central bank wants to relieve the seizure in credit markets without putting the economy in jeopardy. That goal should be lauded.

If this discount window action does the trick, psychologically and otherwise, the job could be done and odds of a near-term fed funds rate cut declined early Friday.

But if Friday's action doesn't ameliorate the pressure on normal financial operations, the risks to the economy on both the inflation and growth side increase.

On the growth side, the risks are obvious: A standstill in normal financing procedures in the economy could lead to higher unemployment and a slower economy. If the Fed believes this is true, they'll want to get ahead of the problem and get the fed fund rate cuts over with. Expect 50 to 75 basis points of cuts by year-end if they go in this direction.

Given that the discount window is "rarely used" and most debt obligations are tied to the fed funds rate,"the cut in the discount rate will impart almost no direct benefit on the U.S. economy," writes Tony Crescenzi, chief fixed-income economist at Miller Tabak and contributor. That "is why it is imperative that the Fed validate this largely symbolic but important action with a cut in the fed funds rate."

Thus far, the discount window has not been excessively used. James Bianco of Bianco Research notes that discount-window borrowings were reported at $271 million for the week ended Aug. 15, up from $251 million the week ended Aug 8. "These are fairly typical numbers," Bianco says. "Therefore, no one that is in trouble has borrowed from the discount window" -- at least not prior to Friday morning's discount rate cut, notwithstanding hysterical cries of economic Armageddon from various talking heads.

Meanwhile, the risks to inflation that have kept the Fed on hold for a year are still in place. Headline inflation is still high, and labor costs have been rising. More importantly, aggressive rate cuts could further deteriorate the value of the dollar, which was recently down modestly vs. the yen and more significantly vs. the euro in response to Friday's Fed action.

A weaker dollar raises the risk of the U.S. importing inflation, which could mean aggressive rate hikes when this storm is over sometime in the next year or so. Michael Darda, chief economist at MKM Partners, recalls that after the Fed's aggressive cuts in response to the October 1987 market crash, the economy endured a four-year period of higher core inflation.

Lastly, the Fed also does not want to bail out the lenders who were overaggressive in lending in the first place. That's not to say they don't care about the public or people hurt by higher rates. The people whose homes were foreclosed on may not benefit from a fed funds rate cut right now as much as they'd suffer under an economy buried by a weak dollar and higher inflation.
Aaron L. Task is editor at large of In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback; click here to send him an email.

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