by Claire Gallen
WASHINGTON, Aug 19, 2007 (AFP) - Investors are fixating on the Federal Reserve after its discount rate cut Friday, hoping the US central bank will take stronger action to ease the credit crunch roiling markets worldwide.
The Fed took markets by surprise Friday by slashing its discount rate, the interest rate charged on loans to commercial banks, by a half-percentage point to 5.75 percent.
Equity markets cheered the decision, announced before Wall Street opened: the Dow Jones industrial jumped 1.82 percent, the first time it closed higher in seven sessions. The news lifted the major European stock markets out of earlier losses.
Yet the central bank did not touch its key federal funds rate -- the overnight rate banks charge each other -- despite investor cries for relief.
The Fed has kept the fed funds rate at 5.25 percent since June 2006, saying its top priority is containing inflationary pressures in the world's biggest economy.
But economists stressed that the Fed's reduction in the discount rate Friday paves the way for further easing of credit in the near future.
In announcing the move, the Fed reformulated its economic outlook, saying "the downside risks to growth have increased appreciably" and it is "prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets."
Craig Alexander, chief economist at TD Bank Financial Group, said a cut in the fed funds rate, which affects the broader economy, is just around the corner.
"The discount rate reduction is telling, as it strongly signals to markets that the Fed is prepared to ease monetary policy if the credit crunch does not dissipate soon," he said.
Alexander noted the next scheduled Fed policy-setting meeting is not until September 18.
"The implication is that a continuation of liquidity pressures in the coming days would likely prompt an inter-meeting rate cut," he said.
Economists said the Fed statement reveals a seismic shift in the bank's risk hierarchy that puts economic growth above inflation.
"It is setting aside its inflation concerns and opening the door to a cut in the target federal funds rate to support growth," wrote analysts at Global Insight, betting on a half-point cut to bring the fed funds rate to 4.75 percent.
But when the Fed will act and the size of a cut is a matter of debate. Many say they expect only a quarter-point reduction.
Stephen Gallagher, an analyst at Societe Generale, said these are just secondary matters.
"A rate cut would send the signal that the Fed is now fully committed to restoring the order, rather than being divided by different objectives," he said. "These signals are more important than the precise rate chosen on any given date."
And, there are some who predict the central bank will leave its key rate unchanged.
By September 18, "financial conditions may have normalized to such an extent that the Fed can hold monetary policy steady," said John Lonski of Moody's Investors Service, although he said the prospects were slim.
Even if the Fed leaves the federal funds rate untouched, it has other arms in its arsenal.
It could, for example, organize a rescue of the collapsed subprime mortgage sector, where loans are made to homebuyers with poor credit, analysts said.
They point to the Fed's rescue in 1998 of Long-Term Capital Management, a large hedge fund on the brink of bankruptcy. The central bank organized a private-sector bailout to avert a broader disruption in the financial markets.
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