Fed cuts rates by 75 basis points

By Krishna Guha in London and Michael Mackenzie in New York

The US Federal Reserve cut interest rates by 75 basis points to 2.25 per cent on Tuesday, a smaller reduction than many in the markets had expected - and a sign that the central bank believes monetary policy alone will not the credit crisis.

In a statement, the Fed said the “outlook for economic growth has weakened further” and “downside risks remain” – leaving the door open to further rate cuts at subsequent policy meetings.

But the Fed also made it clear that policymakers did not cut rates by 100 basis points as many investors expected because of ongoing concerns about inflation.

“Inflation has been elevated and some indicators of inflation expectations have risen,” the Fed said. It said policymakers expect inflation to moderate, but believe “uncertainty about the inflation outlook has increased.”

After a day of sharp gains, markets showed their disappointment that the cut was not bigger, giving up some of their advances on the day.

The Fed decision reflects policymakers’ determination to signal that they are not ignoring inflation. Officials worried that if they cut rates too far, the bond market could rebel, pushing up long term interest rates and with them mortgage rates.

In recent days the US central bank has taken aggressive measures to boost the supply of liquidity to markets, including a new emergency finance facility for investment banks.

Earlier, stocks and credit markets rallied sharply as investors were buoyed by better-than-expected results from Lehman Brothers and Goldman Sachs and anticipated a big Fed rate cut.

First quarter earnings at the two Wall Street firms fell less than analysts had expected, easing concerns about the state of the investment banking sector.

By late afternoon, the S&P 500 was up 2 per cent at 1,300.36. European markets closed strongly ahead, with the FTSE 100 up 3.5 per cent. Shares of Lehman Brothers were up 32 per cent at $42.12.

Even Bear Stearns shares jumped, to nearly $7 in afternoon trading, as investors bet that shareholders might be able to get a better deal than the $2 a share price agreed by JP Morgan Chase for a rescue takeover.

Treasury bond yields were much higher, as recent safe haven buying was reversed. The yield on the two-year note was 16 basis points higher at 1.50 per cent, while the yield on the 10-year note was 11bp higher at 3.42 per cent.

There was much better buying of mortgage and corporate bonds priced over Treasury yields. Interest rate and credit derivatives also rallied as stocks and financials were up sharply.

Ken Hackel, managing director of fixed income strategy at RBS Greenwich Capital said market conditions were improving and that the firmer tone stocks was a boost for fixed income markets. ”There is relief that a Wall Street firm didn’t go down.”

However, he cautioned: ”There is no doubt, liquidity will remain at a premium for some time.”

The improved tone in spreads was also attributed to market rumour that a 30 per cent capital surcharge on Fannie Mae and Freddie Mac, the two government-sponsored enterprises, could be lifted. This would enable Fannie and Freddie to buy more mortgage assets with their existing capital.

The dollar was mixed, weaker against the euro and sterling, but was up 1 per cent against the yen to Y98.20.

However, there was little good news on the underlying economy. While new home starts came in higher than expected, building permits plunged 7.8 per cent in February, suggesting further weakness to come.

US Treasury Secretary Hank Paulson admitted “the economy has turned down sharply” – though he avoided the word recession..”