Stock prices stabilize, inflation falls as Fed forgoes rate cut

McClatchy NewspapersSeptember 16, 2008 

WASHINGTON — A sense of calm returned to Wall Street on Tuesday, leaving weary investors wondering whether it was a return to normalcy or the eye of the storm, even as the day featured the best inflation report in two years and the Federal Reserve chose not to change its benchmark lending rate.

Consumers had reason to cheer as oil prices continued their steep decline, raising the possibility of $3.00 a gallon gasoline in the weeks ahead. Oil prices fell $4.56 to settle at $91.15 on the New York Mercantile Exchange. That's far off the July high of $147 a barrel, and for consumers it means more cash in the wallet soon.

Falling energy prices will do more than lower the cost of gasoline and home heat. They'll also lower the costs of production for farm products and manufactured goods, and that eventually will drive down a two-year rise in inflation that's weakened consumer spending.

Over the past 12 months, thanks to rising energy prices, consumer inflation advanced at an annual pace of 5.4 percent, and 7.2 percent over the past three months. In August, food prices rose 0.8 percent, and 9.6 percent over the past three months.

But on Tuesday, the Labor Department reported that consumer prices fell last month — by 0.1 percent — for the first month since October 2006, a minimal drop but a decline nonetheless.

"Virtually all of the inflation indicators are on the wane: Labor markets are weak and compensation gains slight, inflation expectations are flagging and energy prices continue to fall," Kenneth Beauchemin, an economist with forecaster Global Insight, said in a note to investors. Tuesday's "report grants the Fed more latitude to wield the federal funds rate instrument to address continued credit market strains if it deems appropriate."

On Tuesday, the Fed didn't do so. Its rate-setting Open Market Committee left its benchmark fed funds rate at 2 percent, where it's been since April.

Wall Street had hoped for a quarter-point interest rate cut to support sagging financial markets; floor traders booed after the decision was announced. The Fed didn't signal the possibility of a future rate reduction despite growing fears that Wall Street's turmoil, the banking credit crunch and declining home prices are pushing the economy into recession. The absence of Fed action may have signaled confidence that the economy isn't as endangered as Wall Street's turmoil suggests.

Stocks moved up more than 120 points on the Dow Jones Industrial Average shortly after the Fed's decision. A day after falling 504 points, the Dow finished up 141.51 points to 11,059.02 on Tuesday, while the S&P 500 finished up 20.90 points to 1213.60 and the Nasdaq gained 27.99 to close at 2207.90.

"Strains in financial markets have increased significantly," the Fed statement said, offering little insight into what it intended to do about them. Some financial analysts took that to mean that the Fed was separating Wall Street's problems from Main Street's.

"In doing so, the Fed made clear its desire, to the extent possible, to separate its monetary policy decisions from the circumstances surrounding particular financial institutions," Peter Kretzmer, a Bank of America economist, wrote in a note to investors. "Notably, the Fed made only slight changes to its August monetary policy statement, maintaining a balanced view of the risks facing the economy despite the large recent events in financial markets."

In a bid to ensure normal operations in financial markets, the Fed pumped another $70 billion in short-term lendable funds into the financial system early Tuesday, the same amount it had injected a day earlier. These loans are designed to ensure that banks and corporations have access to short-term loans to meet their cash-flow needs.

Stocks moved into positive territory earlier Tuesday once reports surfaced that officials from the New York Fed were participating in talks with New York's insurance commissioner and others about a possible bridge loan to keep insurance and finance giant American International Group Inc. out of bankruptcy.

"The markets' relatively benign behavior in the wake of the (rate) announcement has nothing to do with the Fed policy statement and everything to do with rumors that the Fed is willing to act on AIG, in our judgment," wrote John Ryding and Conrad DeQuadros, partners in the research firm RDQ Economics. "If no such assistance is forthcoming, we think that market weakness could well force the Fed to cut rates."

The question of what to do about AIG has been hanging over Wall Street. The federal government on Monday rejected AIG's request for a bridge loan to keep it afloat, but it appeared to be back at the table Tuesday after the private sector failed to come forward with a solution.

AIG is no ordinary company. It's a major component of the Dow Jones Industrial Average, a blue-chip company with tentacles in a wide array of U.S. and foreign markets, from life and boat insurance for consumers to complex insurance-like instruments called credit default swaps that are designed to protect institutional investors from defaults on bonds. AIG has a gigantic aircraft-leasing business, and its demise also would send shock waves across the airline industry.

Should AIG declare bankruptcy, it would leave a mountain of legal and financial problems in its wake that would dwarf the collapse of energy giant Enron Corp. in late 2001.

AIG, with assets valued above $1 trillion, is trapped in a vicious Wall Street circle. It raised $20 billion in capital this year to shore up its balance sheets, but investors want to see more, and that's increasingly difficult after credit-rating agencies moved late Monday night to lower its rating.

That means investors can demand that AIG put up more collateral for loans, not an easy thing to do in an environment where companies are being forced to sell assets at giveaway prices or try to raise capital in credit markets that have seized up.

AIG's former chief executive officer, Maurice "Hank" Greenberg, who built and ran the global giant for 35 years, warned Tuesday that allowing the company to collapse would threaten the global finance system.

Interviewed on CNBC, Greenberg said "it is in our national interest" that AIG survive. He argued that a federal loan wouldn't be a bailout because the company is solvent and merely faces a cash problem.

AIG has been forced to raise more capital because of its bad bets on mortgage bonds that remain at the root of the nation's housing and financial crises. Most of AIG's businesses are profitable, however. It's simply unable to raise enough capital to meet its short-term cash flow needs.

The Fed in March allowed investment banks to take out emergency loans to avoid the situation that AIG is in now.

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Tuesday's inflation report

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