Tuesday the stock market began with some modest gains, including a 1% increase for the Dow Jones, and several stocks rallying after Monday’s losses.  Nearing the close of the stock market, in an unprecedented move, the Federal Reserve announced that it had cut its key interest rate to 0-0.25%, down from 1%.  The news sent stocks barreling forward in the closing hours of the market, with the Dow up more than 350 points at 8924.14, and the Nasdaq Composite Index up more than 80 points at 1,589.89. 

Volatility in the stock market has lessened in recent weeks, with several days posting modest gains or losses, however this move by the Federal Reserve caused a huge spike in the market, with more gains predicted Wednesday.  In addition to the cut, the Federal Reserve pledged that it would be using “all available tools” to combat the financial crisis and the recession. 

The Federal Reserve interest rate serves as a benchmark for all kinds of lending and is used to set rates for bank loans including adjustable rate mortgages, credit cards, and business loans.  In general, a bank’s prime loan rate is 3% higher than the Federal interest rate, and several banks announced reducing their prime rate to 3.25% following the Federal Reserve announcement Tuesday. 

Prior to Tuesday, the Federal interest rate was sitting at its all time low of 1%, and most economists anticipated the Federal Reserve lowering the rate to 0.5%.  The move to a lesser amount, including adding a range on the interest rate, was unexpected, and more aggressive than most predicted.  President-elect Barack Obama said of the Federal Reserve’s recent cut:

The Federal Reserve is running out of the traditional ammunition to combat the recession, and it is important that other branches of the government step up.

Many had fears that the Federal Reserve was running out of methods in which to combat the financial crisis and the recession, but with this move it seems that the government is kicking it into second gear, rather than running on depleted resources.  The chief investment officer at Harris Private Bank, Jack Ablin, said of the Federal Reserve’s decision:

The Fed is saying that it’s pretty much out of dry powder for its primary weapon, but it has other weapons available to combat deterioration in the economy.

There has been a steady stream of downbeat economic news on Wall Street since last week, including a growing list of companies affected by Madoff’s multi-billion dollar scam, a 20% drop in home construction, and sinking consumer prices.  Despite all of this, the stock market has shown remarkable resilience, illustrating that people just might believe the economy has worsened to the extent that it can only get better.  Weeks ago the stock market was climbing and dropping by 5% margins on alternating days as both good and bad news surfaced.  With the recent stability, it’s possible like it hasn’t been in months that the market has found its bottom.  The huge interest rate cut from the Federal Reserve just might be the last nail needed to hold up the bridge. 

Despite Wall Street’s positive attitude towards the interest rate cut, it is not without potential risks.  The government has funded all of its recent debt by selling it off in the form of Treasury Bills, and the levels at which Treasuries are being bought is unsustainable in the long term.  In a couple years, this could mean huge amounts of government debt floating around with no one left to buy it, resulting in the devaluing of the dollar. 

The entire U.S. economy and economies around the world are based on purchasing consumers purchasing items they can’t afford in the short term.  The current credit crisis was spurred by the sub-prime mortgage crisis, which in turn stemmed from consumers purchasing homes they couldn’t afford; it just came back to bite them sooner than expected.  Though selling off debt is a way to have more purchasing power in the short term, it doesn’t seem like the best long term solution.  The real question is, will the U.S. be able to purchase all of its debt back, and if so, when? 

Though the lasting effects of the Federal Reserve’s rate cut will not be known for several years to come, in the short term it is a solution that has generated a favorable reaction from most economists and in the stock market.  The Federal Reserve justified its rate cut by stating that the economy was in danger of getting weaker, and that the risk of inflation had decreased significantly.  The lower rates are designed to encourage consumer spending by making borrowing more affordable.

The policies that will fix the economy are in place or in the process of being implemented; now there is a need to jumpstart consumer spending more than fix the problems which are hindering it.  In 2009, the speed at which the economy starts to post positive gains won’t be all up to the government; a large part will be in the hands and wallets of the average American.

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