Will the Fed's move save stocks?

By Charley Blaine

The Federal Reserve's decision to cut its discount rate Friday generated a big, broad stock market rally, but that doesn't mean this summer's turmoil is over.

Bailing out investors who had seen the major averages drop 10% or more since mid-July wasn't the central bank's intention Friday. It wanted to prevent a collapse of the credit markets, and the move seemed to have worked.

At the close on Friday, the Dow Jones industrials were up 233 points, or 1.8%, to 13,079. The Standard & Poor's 500 Index was up nearly 35 points, 2.5%, to 1,446, and the Nasdaq Composite Index was up nearly 54 points, 2.1%, to 2,505.

The Fed cut from 6.25% to 5.75% the interest rate it charges on loans it makes directly to member banks that are short on the funds to go about their daily business. The rate cut came after several moves in the last week to inject cash into the nation's financial system to try to soothe jittered markets.

That helped ease the problem of the last two weeks, where financial institutions that routinely lend each other cash for a day or two stopped making those loans. Stopping or delaying loans even for reputable customers caused a potentially dangerous credit crunch.

Many analysts said they believed the move should give investors confidence to buy stocks after the sell-off since July 19.

"You've gone from complete despair and pessimism on the part of investors to a calming but still very fluid and volatile period ahead," said Ned Riley, chief investment strategist at Riley Asset Management, told CNN Money.

But there was plenty of skepticism as well. "I think it signals somewhat of a panic move by the Fed here, and I would not have too much faith in this rally," said Joe Ranieri, co-head of trading at Canaccord Adams, told The Wall Street Journal.

• Dow up 233 on Fed's discount-rate cut

The Fed felt it needed to act to get those transactions moving again, and it followed up the announcement by holding a teleconference to encourage banks to borrow money directly from the central bank.

A statement Thursday by William Poole, president of the Federal Reserve Bank of St. Louis, that no Fed action was needed damaged the Fed's standing on Wall Street.

The comment was "absolutely destructive," said Peter Morici, a University of Maryland economist and former chief economist with the U.S. International Trade Commission.

Friday's move was as much psychological as practical. "The Fed is stepping in to say, 'We are riding with you,'" Morici said. (And Poole, it should be noted, didn't take part in the Fed's decision, made Thursday night.)

The discount rate cut by itself was important. It's used to help the economy less than the federal funds rate, and, as Morici noted, "It is generally reserved for more severe situations."

But equally important was the Fed's statement that it now saw considerable downside risks to the economy, something it hadn't said over the last year.

The damage from a credit crunch

Investors have been worried that a credit crunch would increase the pressure on mortgage lenders like Countrywide Financial (CFC, news, msgs) and Washington Mutual (WM, news, msgs). Countrywide shares, in fact, were up nearly 11% Friday afternoon to $21.01. Washington Mutual shares, up 9% on Thursday, were up 6.3% to $37.81 Friday.

The Fed also may cut its federal funds rate, which has been at 5.25% for more than a year, to keep the economy weakening. Most analysts expect a cut to 5% or, more likely, to 4.75%, when the Fed's rate-making body, the Federal Open Market Committee, meets on Sept. 18.

The fed funds rate is the rate that banks charge each other for overnight loans. The Fed controls it by its buying and selling of securities. The rate started to jump when the problems of subprime mortgages and hedge funds began to spread from the United States around the world.

Market still faces challenges

But a rate cut can only go so far. The stock market still faces some hurdles, beginning next week when the Commerce Department reports new-home sales for July. A report on housing starts Thursday was dismal, with starts and building permits (a key indicator of future building) off 20% or more from a year ago.

Meanwhile, the markets will have to deal with an economy that's softening more rapidly than thought. Housing is slumping. Auto sales are down, especially for domestic automakers. And there has been increasing evidence of softness among retailers. Wal-Mart Stores (WMT, news, msgs) pointedly noted that some of its customers were running out of cash at the end of the month.

Even the Fed noted this in Friday's statement: "Tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward."

Meanwhile, Wall Street is still digging through the files of its hedge funds that invested in real-estate-related securities. The great fear, traders say, is if a big hedge fund collapses, which would be a major blow to investor confidence.

"If the markets don't stabilize over the next few weeks, there's little doubt the Fed will move again," Philippa Dunne and Doug Henwood of the Liscio Report