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Is the Fed Smart, Dumb, or Both?

Even as rapidly as the markets have been moving lately, they can't rival the speed at which public opinion of Ben Bernanke changes. One day, the market thinks the Federal Reserve chairman is the dumbest guy on Earth. The next morning, he's the master of the universe. The reality, of course, falls somewhere in between -- but try telling that to the traders who got whipsawed not once, not twice, but three times ... and counting.

Bipolar markets
Yesterday, stocks tanked after the Fed decided to cut the federal funds rate by 0.25%. Many observers, pointing to evidence of a slowing economy and the ongoing troubles in the credit markets, had been hoping for a more aggressive 0.5% cut. Especially with inflation still relatively tame -- despite high energy and food prices -- the Fed was seen as having room to make a larger cut. Its decision not to do so disappointed the markets, and the Dow slid more than 300 points from its pre-release levels.

Yet this morning, the Fed came out with better news. Working with central banks in Canada, England, and Switzerland, as well as the European Central Bank, the Fed will act to make it easier for private financial institutions to lend each other money by adding more liquidity to the financial system. The Fed will make short-term loans of tens of billions of dollars to banks through an auction process beginning next Monday. Other central banks will use other methods, including accepting a broader range of collateral from financial institutions seeking loans. The Fed also established currency-swap arrangements with its European counterparts to make sure they have access to U.S. dollars if needed.

That news sent stocks soaring, enough for them to recapture nearly all of their losses from the day before. Yet as trading continued, the gains moderated as traders looked beyond the immediate impact of the two Fed actions.

What it means to you
Although decisions about the federal funds rate get a lot of attention, they generally have little immediate impact on the economy. Rate cuts can take months to result in changes to economic growth.

The Fed's proposal to inject liquidity, on the other hand, directly addresses structural challenges that the credit markets have faced in recent months. Despite the Fed's actions to lower short-term interest rates, loan activity between banks has slowed to a crawl, and rates on those interbank loans have remained stubbornly high. If central bank actions succeed in freeing up banks to lend to one another, financial markets will have overcome a huge hurdle in resolving the credit crisis.

Yet it hardly resolves all of the problems that financial stocks face. Despite some positive sentiment this morning, it's clear that investors aren't seeing the Fed proposal as a panacea. Shares of Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , Wachovia (NYSE: WB  ) , and Citigroup (NYSE: C  ) all fell sharply.

A bump in the road
For long-term investors, this episode provides just one more example of how it's impossible to predict short-term market movements. With sentiment moving from despair to joy and back again in less than 24 hours, you could easily have lost money twice in a row if you had reacted emotionally to each new development.

Don't let individual news items lead you astray. As long as you have a solid plan for your investments, having confidence will help you stay on target to reach your financial goals.

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10/27/2016 4:00 PM
BAC $16.91 Up +0.04 +0.24%
Bank of America CAPS Rating: ****
C $49.93 Down -0.08 -0.16%
Citigroup CAPS Rating: ***
JPM $69.23 Up +0.10 +0.14%
JPMorgan Chase CAPS Rating: ****
WB.DL2 $5.54 Down +0.00 +0.00%
Wachovia Corp CAPS Rating: **