By James Langton

(January 3 – 15:50 ET) – In a move that surprised virtually everyone, the Federal Open Market Committee of the U.S. Federal Reserve Board decided to cut its target for the federal funds rate by 50 basis points to 6%.

Stocks are rallying heavily on the news. The Dow Jones industrial average is up more than 300 points to 10,963. The Nasdaq composite has also gained more than 300 points to 2,601.

In a related action, the Fed also approved a 25 basis point cut in the discount rate to 5.75%, the level requested by seven Reserve Banks. The Fed also indicated that it stands ready to approve a further reduction of 25 basis points in the discount rate to 5.5% on the requests of Federal Reserve Banks.

The Fed says, “These actions 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.”

It notes that it is free to make this move because inflation pressures remain contained. and long-term advances in technology and productivity gains remain.

Analysts remain slightly baffled by the surprise move from the Fed, which has carefully telegraphed most of its recent actions. Merrill Lynch chief economist Bruce Steinberg says, “Currently we are trying to discern why they took this step today.”

Of course most market watchers are pleased initially, but Steinberg cautions, “This does not mean that the economy will turn around suddenly. There is a lag between a rate reduction and its economic impact. However, this announcement gives us more confidence in our belief that the economy will be strengthening by the second half of the year. In the meantime, we believe the economy will not be shrinking but just growing more slowly.”

“The rate cut is uniformly bullish for the equity markets over the intermediate-term,” says Merrill’s chief market strategist Christine Callies. She notes that within three months after an initial rate cut the S&P 500 has generally traded up around 10%, within six months the index has generally advanced 19% and by 12 months it has generally returned 23.6%.

“In the past few weeks the leadership in the equity markets has already tilted toward these constructive growth cyclical themes and away from the economically defensive groups,” says Callies. “We would also note that over 60% of S&P industry sectors have been up over the past month and this may imply that market liquidity is spreading out among group helping to set the stage for a broad advance.”
-IE Staff