WASHINGTON — Stocks roared back Tuesday in the biggest daily gains on Wall Street since July 2002 after the Federal Reserve cut its benchmark interest rate by three-quarters of a percentage point, but shadows still hover over the economy.
The Dow Jones Industrial Average shot up 420.41 points, or 3.5 percent, to 12,392.66. The S&P 500 rose 54.14 points to 1330.74 and the NASDAQ was up 91.25 points to 2268.26, both up more than 4 percent on the day.
Sustaining Tuesday's rally may prove challenging, however, especially given the Fed's explicit warning that expectations of inflation are rising.
The new warning on inflation, coming very high up in the Fed's statement, was a troubling reminder of how complicated the job has become for the guardian of the U.S. economy.
The Fed is wrestling with a housing-market disaster, and perhaps recession in the broader U.S. economy. Then, too, there are malfunctioning credit markets and investment banks that remain vulnerable to investor runs that could bankrupt them. Now inflation is back on the list of concerns, complicated by sky-high oil prices and a falling dollar.
"Inflation has been elevated, and some indicators of inflation expectations have risen," the Fed's Open Market Committee wrote in the third paragraph of its statement announcing two separate rate cuts.
Fed Chairman Ben Bernanke is an inflation hawk who's frequently warned that expectations about inflation are as important as inflation itself. That's because if businesses expect inflation — rising prices across the economy — they raise their own prices, helping to spur the problem.
The Fed's public focus on inflation expectations may be designed to bolster the U.S. dollar by alerting the world that the central bank is paying attention. The dollar's value has slid against major currencies as investors feared that the Fed was willing to tolerate rising inflation _which weakens the dollar's purchasing power — in order to boost the slumping U.S. economy.
After the Fed's statement noting inflation's risk, the price of gold — an investor hedge against inflation — fell. After closing a day earlier in quadruple digits, futures contracts for April delivery of gold fell $24.70 to $977.80 an ounce.
And although the dollar has slid alongside earlier rate cuts, it rebounded Tuesday against foreign currencies, suggesting that the Fed's statement may have bolstered its credibility as an inflation fighter.
The Fed has been reluctant to intervene in currency markets to support the falling dollar, especially since the currency's decline has made exports less expensive and become a bigger driver of the U.S. economy.
The vote by the Fed's rate-setting committee wasn't unanimous, which is unusual. Two governors — Reserve Bank of Dallas President Richard Fisher and Reserve Bank of Philadelphia President Charles Plosser — voted against the deep cut, wanting less aggressive action in light of inflation concerns.
"The focus on inflation expectations is well placed, but the interpretation that it is rising significantly is misplaced," said Mark Zandi, the chief economist of Moody's Economy.com, a forecaster in West Chester, Pa. "By being less aggressive . . . the FOMC will likely be forced to be even more aggressive in the future."
The Fed brought down the discount rate, which it charges banks for short-term loans, to 2.50 percent. It brought down the federal funds rate — which banks charge each other for overnight lending — to 2.25 percent. That's 3 percentage points below where it stood last September, underscoring the Fed's aggressive action to make borrowing cheaper and thus spur the economy. It's cut the rate six times since September.
Commercial banks followed the reduction in the fed funds rate, lowering the prime rate — charged to their best customers — to 5.25 percent. That could lower the cost of credit card debt, boost car purchases and help some homeowners with adjustable-rate mortgages.
The Fed's statement also signaled that it's prepared to cut further, noting that "downside risks to growth remain."
"What the markets are reacting positively to . . . is the fact that the Fed has responded very aggressively to the escalation of downside risks to the economy and crisis in the financial markets in the past six months," Brian Bethune, U.S. economist for forecaster Global Insight in Lexington, Mass., said in a note to investors. He predicted another half-point cut in April.
The financial sector on Tuesday reversed the steep losses of a day earlier. Stocks were boosted even before the Fed's action by earnings reports from investment banks Goldman Sachs and Lehman Brothers that weren't as bad as analysts had expected.
Goldman reported a 53 percent drop in net income for the quarter compared with the same period last year, and Lehman a 57 percent drop. But both still earned profits, with Goldman's net earnings for the latest three months at $1.51 billion.
Share prices for Lehman Holdings, the parent company of Lehman Brothers, rose 46.43 percent. That bought breathing room for the investment bank that's viewed as the most likely domino to topple next.
Lehman's chief financial officer, Erin Callan, told CNBC after markets closed that the bank still expects "rough sledding" well into next year. The Fed's announcement Sunday night that it'd accept mortgage bonds as collateral should help ease concerns about bank failures, she said.
Share prices for Goldman Sachs rose 16.27 percent and Citigroup share prices rose 11.22 percent.
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The Fed's statement.