Surprise rate cut spurs stock rally

Fed lowers key rate by a half-point for fourth time this year

Aggressive new policy

Nasdaq soars 156.22, Dow rises 399.10 in near-record trading

April 19, 2001|By William Patalon III | William Patalon III,SUN STAFF

In a move that surprised economists and ignited a major rally in stocks, Federal Reserve policy-makers cut a benchmark interest rate by half a percentage point yesterday, the fourth time this year that the newly aggressive central bank has slashed borrowing costs so steeply.

The policy-making Federal Open Market Committee, headed by Fed Chairman Alan Greenspan, noted eroding profits and a worsening outlook for corporate capital spending as two of the reasons for the rate cut.

"The significance here is that he's going to do whatever needs to be done to keep the economy from falling apart," said David M. Citron, managing director of the Pikesville office of Carret and Co., a Manhattan-based money-management business.

That probably means further rate cuts. A Reuters poll of top Wall Street firms yesterday found that 24 of 25 expected another interest-rate reduction at the conclusion of the policy-making committee's next meeting, scheduled for May 15. Fifteen firms forecast a cut of half a percentage point, seven expected a quarter-point reduction, and two thought a cut of either magnitude was equally likely.

Yesterday, the committee pared the key overnight lending rate by a half-point, to 4.5 percent, the lowest it has been in six years. It was the second time this year that the Fed had surprised economists by cutting rates between meetings.

The decision was made during an 8:30 a.m. conference call that lasted less than an hour and was announced later in the morning.

Near-record rallies

Yesterday's mid-April surprise, along with Intel Corp.'s announcement that its earnings will beat forecasts, sparked near-record rallies in several of the major indexes.

The technology-heavy Nasdaq composite index soared 156.22 points, or 8.12 percent, to close at 2,079.44. The Dow Jones industrial average jumped 399.10 points, or 3.9 percent, to end the day at 10,615.83. It was the fourth-largest percentage gain for the Nasdaq and the third-largest point gain for the Dow.

Trading volume also came close to a record. About 1.9 billion shares changed hands on the New York Stock Exchange, according to preliminary figures, while roughly 3.1 billion shares traded on the Nasdaq. It was the second-highest total for both.

In addition to reducing the overnight lending rate - what Fed member banks charge one another for overnight loans - by a half-point, central bankers also cut the more-symbolic discount rate by the same amount, dropping it to 4 percent.

The goal of the Fed is, in part, to reduce borrowing costs for consumers and corporations, which energizes economic activity because it jump-starts the flow of money through the economy.

Banks trim prime rates

The response was nearly immediate. Bank of America, J. P. Morgan Chase & Co. and other large U.S. banks trimmed their prime lending rates yesterday by a half-point, to 7.5 percent.

Now that the Fed has placed the wind at the back of the economy and the stock markets, many investors and analysts predict that stocks will bolster their gains in coming trading sessions.

"A rally of this magnitude can't be ignored," said Angel Mata, senior vice president of equity trading for Legg Mason Inc. in Baltimore.

Others disagree, contending that stocks are still expensive compared with their historical norms, meaning sell-offs that set new lows are very possible.

Unsettling indicators

For instance, even though the S&P 500 remains well off its high, its price/earnings ratio is still 24. And that's unsettling, one professional investor says, because the P/E of that index never before peaked above 21, a point it neared just before major sell-offs started in 1929, 1972 and 1987.

Worse, the S&P's historical median is 14, a point that would require an additional decline of 29 percent to reach, said John P. Hussman, portfolio manager of the Hussman Strategic Growth Fund, a mutual fund based in Ellicott City.

"It's not a pleasant thought at all," Hussman said.

During its current rate-reduction campaign, the Fed has consistently waited for the right time to roll back interest rates, many economists and experts say. If the central bank cut rates too quickly, without waiting to see what the most recent data had to say about the state of the economy, the Fed would run the risk of firing all of its bullets and being "left with an empty gun," said Mata of Legg Mason.

Some Fed-watchers have said that the current campaign was made necessary by a central bank that was far too aggressive when it raised interest rates in 1999 and last year to slow a white-hot economy that was threatening to boil over.

The Fed's new policy

After three quick interest rate reductions in late 1998 - designed to counteract the potentially infectious impact of a hedge fund failure and the Asian financial crisis - the Fed raised interest rates six times from June 1999 to May of last year.

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