The Fed's Move: Cause for Joyor Worry?

The rate cut at first sparked stock market elation. But if the Fed's fears of a slowdown come true, profits and stocks could suffer big-time

If you're worried about an economic slowdown, the last two days have been confusing. First, you find out that U.S. central bankers share your concerns: The Federal Reserve cut the fed funds rate by half a percentage point on Sept. 18, a bigger move than many were expecting.

But then the U.S. stock market responded to the Fed move with elation. The S&P 500-stock index surged 3.5% in the four hours of trading after the Fed announcement.

The Fed may be worrying about a slowdown or a recession, but the stock market, with indexes approaching all-time records, suddenly seemed far more relaxed.

Experts say markets were relieved that the Fed was taking strong action against threats to the housing, mortgage, and broader credit markets. The labor market, which until recently had held up fairly well amid the housing downturn, may have been the final piece of the puzzle for policymakers. Data released Sept. 7 suggested the slowdown in housing hurt hiring over the summer, and that may have sealed the deal for a larger rate cut.

Fed Action: A History Lesson

But history offers a mixed lesson for those now hoping that the rate cut puts behind us the summer's credit crisis and the other threats to growth.

Until this week, the last time the Fed moved from raising rates to cutting them was Jan. 3, 2001, when the Fed unexpectedly dropped the Fed funds rate by half a percentage point. Stocks initially surged in January, celebrating the lower interest rates. But then the economy's weakness, particularly in the tech sector, became clear. The S&P 500 fell 10.5% in 2001. To fight a slowdown, the Fed cut rates 12 more times in the next two years.

The longer-term record for rate cuts is better. Ed Yardeni of Yardeni Research looked at the 13 times the Fed has started cutting rates and how the stock market reacted. On average, the S&P 500 was up 3.7% in the three months after an initial cut and 9.5% in six months. Sam Stovall of Standard & Poor's examined 10 interest rate cuts from 1954 to 2001 and found that six of those times the S&P 500 was higher six months later (see accompanying table). (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies (MHP).)

Credit Market Confidence

So is the rate cut of Sept. 18 more like 2001, when the Fed moved just as the economy started to slow down? Or is it like other rate cuts that coincide with temporary mid-economic cycle slowdowns or that resolved brief financial crises?

Interest rate cuts tend to boost economic growth, but economists say the full effects often take a year or longer to show up. That suggests the latest rate cut should have little effect on growth in late 2007 and early 2008.

But many on Wall Street said they were hoping the Fed's moves have more immediate effects—like restoring badly needed confidence to the credit markets.

"This shows the cop is on the beat," says Douglas Peta, market strategist at J. & W. Seligman.

There is "confidence now that the Fed is aware that the economy is weak and acting accordingly," says Kurt Karl, chief North American economist at Swiss Reinsurance (RUKN). His biggest worry: The Fed move won't be enough to keep the business community spending on new investment.

Odds on a Recession?

Peter Cardillo, chief market economist at Avalon Partners, says the Fed move may bring down some borrowing costs, such as on credit card debt, and may help consumer confidence just before retail's important holiday season.

The crisis on the credit markets, which surfaced this summer, was causing many economists to place higher odds on a recession. But the rate cut caused a few to change their tune. Yardeni, for example, put the chance of a recession at 30% but then cut his prediction to 15% after the rate cut. Karl says he now places recession's chances at "35% and falling."

Overall, economists were hoping Fed action would short-circuit a destructive cycle on the financial and housing markets. Recently, housing was "having more of an impact on financial markets' perceptions of risk"—causing major credit market disruptions—"and on employers' willingness to hire," said Avery Shenfeld, senior economist at CIBC World Markets (CM).

It's not clear how long the new optimism on Wall Street will last.

Watch the Jobs Data

Cardillo points out that much of the stock market's initial reaction to the Fed move may have been more a response to short-sellers getting squeezed. J. & W. Seligman's Peta wonders if a reduction in the cost of borrowing will prompt skittish credit investors to actually start lending money again.

Wachovia (WB) Chief Economist John Silvia says the Fed move could immediately help the U.S.'s large financial sector. But he is waiting for economic data from September to arrive before he adjusts his recession prediction, which he rates as a 32% chance. Particularly important is the employment picture: Jobs data from this summer showed a sharp slowdown in hiring.

Many economists warn that problems with credit markets may be with us for several more months. Residential mortgages continue to default, and the housing bubble is still mid-pop, says Chris Brendler of Stifel Nicolaus (SF). "Housing prices still need to fall 10%, which will cause foreclosures and mortgage loan losses," he wrote on Sept. 19.

The key question may be how many more times the Fed feels the need to cut rates. Another rate cut in October could be a sign that a slowdown, if not a recession, is imminent. If so, Cardillo says, corporate profits, and perhaps the stock market, could take another big hit.

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