Stocks fall sharply after Fed cuts rates

Wall Street plunged Tuesday after the Federal Reserve lowered interest rates by a quarter point, disappointing investors who hoped the Fed would move more aggressively to help the economy overcome the credit and mortgage crisis. The Dow Jones industrial average skidded more than 290 points.

Investors had been expecting policymakers would cut rates for a third straight time, though there was debate over the size of the cut. Most economists had been expecting a quarter-point cut in the benchmark federal funds rate to 4.25 percent -- but some investors were hoping for a half-point cut in the Fed's last meeting this year, and their disappointment took the market sharply lower.

Wall Street had barreled higher the past two weeks, propelling the Dow up 640 points partly on rising optimism that the Fed would do all it could to prevent the economy from slipping into recession. While the Fed indicated Tuesday it was doing exactly that, the market's expectations had run well ahead of the central bank's view of the economy and what it needed.

Fed officials did signal that further cuts are possible if a severe downturn in housing and a crisis in mortgage lending worsen, but that was not enough to assuage the market.

Moreover, the central bank did note that the economy has suffered. The statement accompanying the Fed's decision said "information suggests that economic growth is slowing," and removed language from prior statements stating that risks to the economy are balanced. But the Fed seemed to stand firm on a quarter-point cut for now.

In addition to cutting the funds rate, the Fed announced it was reducing its discount rate, the interest it charges to make direct loans to banks, by a quarter-point as well to 4.75 percent. This reduction was aimed at encouraging banks to borrow more freely from the Fed at a time when there are worries that a rising number of bad loans will prompt banks to tighten credit conditions too severely, adding another strain on the already fragile economy.

The Fed embarked on this round of rate cuts in September in response to severe turbulence in credit markets around the globe as investors reacted to various reports of mounting losses from defaults in subprime mortgages, the latest fallout from the worst slump in the U.S. housing market in more than two decades.

After cutting the funds rate by a half-point on Sept. 11 and a quarter-point on Oct. 31, the central bank indicated that those two reductions might be all that were needed to combat the threat of a recession given that financial markets appeared to be stabilizing.

However, increased market turbulence following the October meeting and growing fears of a recession caused the Fed to do an about-face.

In a brief statement explaining its action, the Fed said that recent economic data indicated that the economy is slowing, "reflecting the intensification of the housing correction and some softening in business and consumer spending."

The Fed also noted that "strains in financial markets have increased in recent weeks."

In its Oct. 31 statement, the Fed said it viewed the risks from weak growth as roughly balanced with the risks of higher inflation.

However, that phrase was changed in the current statement to read, "Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation."

The Fed vote for the rate cut was 9 to 1 with Eric S. Rosengren dissenting, arguing for a bigger, half-point cut in the funds rate.

Many economists believe the housing slump and credit turmoil have raised the risks of a recession. Many analysts believe that economic growth, as measured by the gross domestic product, may have dipped to a barely perceptible 1 percent rate, raising the chance that some shock, such as another surge in energy prices, could push the country into a recession.

But many analysts still believe the Fed will be able to respond forcefully enough with rate cuts that it will keep the current expansion alive. These analysts believe that the economy will start to rebound to faster growth by the middle of next year, when they expect that lower mortgage rates will have spurred a rebound in home sales.

"I think a full blown recession can be avoided but just barely," said David Jones, chief economist at DMJ Advisors. He predicted that the Fed will follow up its December rate cut with three more reductions at its first three meetings of 2008.