Rate Cut Juices Market

The Federal Reserve lowered interest rates today, improving the financial picture somewhat for money-hungry corporations. Despite the market's rebound, though, this news shouldn't be taken by investors as a sign that 1999's happy days are here again.

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By Bill Mann (TMF Otter)
January 3, 2001

In a move that both surprised and bolstered the stock market, the Federal Open Market Committee (FOMC) decided it has seen enough of slowing sales, slipping consumer confidence, and tumbling corporate profits, and responded by lowering the discount rate by one quarter percent and the more-important federal funds rate by 50 basis points, or one half of one percent. The Fed also said it would consider additional discount rate cuts should the business environment not improve.

"These actions," said the Fed in a press release, "were taken in light of further weakening of sales and production, and in the context of lower consumer confidence, tight conditions in some segments of financial markets, and high energy prices sapping household and business purchasing power. Moreover, inflation pressures remain contained."

"Nonetheless," the release continued, "to date there is little evidence to suggest that longer-term advances in technology and associated gains in productivity are abating. The Committee continues to believe that, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future."

U.S. and global stock markets immediately jumped on the news, with the Nasdaq composite -- replete with hundreds of companies that need easier access to working capital -- jumping by more than 11% in minutes. This was the first rate cut of 50 basis points since 1992, and leaves the fed overnight rate at 6%. Essentially this means that the Federal Reserve Bank of New York will be buying dollars on the open market, and thus lowering the cost of capital to banks and other institutions. The essence of these moves will encourage lenders to increase the amount of capital they are willing to loan, at lower rates. The end result is that liquidity, represented by greater access to capital by a greater number of borrowers, will increase, making debt cheaper as more lenders compete to place loans.

In my opinion, the Fed's decision to make this move right now is somewhat puzzling. We are four weeks in advance of the next FOMC meeting and only two days into the new year, and thus the new quarter for most corporations. To cut the overnight rate so drastically means that there is likely some economic data point that really spooked Chairman Greenspan. Perhaps he got an advance look at the unemployment numbers, which are due out this Friday, and they are much higher than predicted. This rate cut means that officially the Federal Reserve Board's chief concern is no longer inflation, but rather recession.

Stock market surges like today's need to be taken in context of the news that causes them. December's unemployment rate was only 4%, which keeps it at a level that economists until recently considered inflationary. This means that there is some other factor that threatens Greenspan's desired "soft landing" -- and that factor is NOT the stock market, which the Fed generally does not use as a barometer of economic strength. So while the environment has just gotten a little better for most businesses to operate, an assumption that we will simply return to the market environment of 1999 is simply unrealistic.

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