Stocks surge on Fed cut

US stocks staged their biggest rally in more than five years yesterday as confidence in the stability of the financial system grew and the Federal Reserve cut interest rates by 75 basis points to 2.25 per cent.
The rate reduction was smaller than many in the markets had expected but investors overcame their initial disappointment, and shares, which had been up strongly before the Fed action, closed still higher.
In cutting rates, the US central bank tried to balance the threats to growth and inflation. However, in a rare move, two members of the Fed's policymaking Open Market Committee dissented in favour of a 50bp cut, indicating the depth of resistance at the Fed to even a 75bp move.
The size of the cut, while large by historical standards, suggests the Fed believes it will not be able to solve the credit crisis through monetary policy alone.
The central bank said the "outlook for economic growth has weakened further" and "downside risks remain", leaving the door open to further cuts in the main Fed funds rate at subsequent policy meetings. The Fed also cut the discount rate at which it provides emergency finance by 75bp to 2.5 per cent.

However, the Fed hardened its language on inflation, making it clear that policymakers had not cut rates by 100bp because of concerns about price pressures. "Inflation has been elevated and some indicators of inflation expectations have risen," the Fed said. It said policymakers expected inflation to moderate but believed "uncertainty about the inflation outlook has increased".

The Fed's decision reflects policymakers' determination to signal that while they are focused on fighting growth risks, they are not ignoring inflation. Officials worry that if they cut rates too far, the bond market could rebel, pushing up long- term interest rates and, with them, mortgage rates. In recent days, the US central bank has taken aggressive measures to boost the supply of liquidity to markets, including a new emergency finance facility for investment banks.

The S&P 500 yesterday gained 54.14 points, or 4.24 per cent, to 1,330.74. It was the biggest gain in percentage terms since October 15 2002.

"Initially, the market was disappointed but it appears the market thinks that if the Fed just needs to cut by 75bp, things may not be as bad as feared," said Doug Peta, strategist at J&W Seligman. "It means the Fed can save some bullets."

The S&P investment bank index advanced 16.7 per cent as investors were buoyed by better-than-expected results from Lehman Brothers and Goldman Sachs. European markets closed ahead, with the FTSE 100 up 3.5 per cent.

Ted Wieseman, Morgan Stanley economist, said: "The FOMC meeting actually ended up being a relatively minor event compared to the day's main theme - a big sigh of relief about financial sector stability."

Yields on short-term Treasuries rose as investors turned away from the safe haven of government debt and bought mortgage and corporate bonds. The dollar strengthened.

Hank Paulson, US Treasury secretary, admitted that "the economy has turned down sharply", though he avoided the word recession. He told NBC the "big focus on the part of all policymakers is to minimise the spillover to the real economy".

Building permits fell 7.8 per cent in February. Investors speculated that a 30 per cent capital surcharge on Fannie Mae and Freddie Mac, the government-sponsored housing financiers, could be lifted, sending their shares up 27 per cent and 26 per cent, respectively