Stock markets’ plunge puts pressure on Fed to cut rates

Following a wild and woolly day in the stock market, the world’s central banks are now under intense pressure to drop interest rates.

If the banks agree to a coordinated rate cut, economists expect it to be between one-half and three-quarters of a percentage point.

The catalyst for a cut was today’s roller-coaster day on Wall Street where the Dow Jones Industrial Average at one point was down 800 points but ended with a loss of 369.88 points, a loss of 3.58 percent.

“We need a coordinated rate cut,” says Fred Dickson, chief investment strategist at D.A. Davidson in Lake Oswego, Ore. “You would think the fall of 800 points would catch the Fed’s eye. And a coordinated rate cut would help” ease the credit crisis.

The call for the rate cut came despite the efforts by the Fed to unclog the financial system. On Monday, the Fed said it would increase its loans to banks to $900 billion. And on Monday, the Fed said it would begin to pay interest on banks’ excess reserves and required reserve requirements. This will give the commercial banks greater profit but reduce the Fed’s profitability.

“Together, these actions should encourage term lending across a range of financial markets in a manner that eases pressures and promotes the ability of firms and households to obtain credit,” said the Fed in a statement. “The Federal Reserve stands ready to take additional measures as necessary to foster liquid money-market conditions.”

Some credit-market participants said the Fed’s moves would help somewhat. “Little things may help, but the markets are pretty crazy,” says Bob MacIntosh, chief economist at Eaton Vance in Boston. “I can tell you the credit markets are still lousy.”

Although there was no specific news item that precipitated the stock market drop, Mr. Dickson wonders if some large hedge funds, which have borrowed heavily, are getting margin calls. But he notes that the market’s sharp drop also comes at a time when analysts are reducing their earnings estimates for the fourth quarter. And “right now we have a crisis in confidence in the banking system,” he says.

In fact, some economists wonder if an interest-rate drop will help. “Interest-rate levels are not the problem,” says David Wyss, chief economist at Standard & Poor’s in New York. “The problem is that no one is lending any money.”

Last week, for example, the commercial-paper market – short-term lending to everyone from large corporations to states and cities – shrank by nearly $100 billion or 6 percent. On Monday, the overnight interest rate for prime commercial loans was 3.68 percent, as high as interest rates right after the House of Representatives voted down the $700 billion bank rescue plan last Monday.

The dry spell has at least two states, California and Massachusetts, calling for government loans. “The tax-exempt money-market funds are just afraid to lend,” says Mr. MacIntosh. “They have the cash, but they literally do not want to put it to work.”

The turmoil in the credit markets means that many large corporations that normally would access the commercial-paper market have not been able to do so. GMAC, for example, was unable to get investors to buy a $2.7 billion offering from its commercial finance unit. The offering was withdrawn. “It’s just an example of how shaky the financial markets are,” says Dickson.

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