Coming Week: Still Shaky?

After a welcome weekend respite from the market's turbulence, investors will quickly learn in the coming week whether Friday's Fed-induced rally was just short-term relief or something more sustainable.

Much of that may depend on whether the Fed's move Friday to slice the rate charged at its discount lending window was enough to loosen the noose around normal lending operations around the world. The credit markets remain the lynchpin for any sustained stock market recovery.

"We are certainly not out of the woods yet," says Mike Malone, trading analyst at Cowen & Co. "The markets will remain volatile ... until the large dislocations in the currency and credit and equity markets are worked through. That will take some time."

But, if the Fed's step shores up enough confidence to quell fears of financial system collapse, perhaps the central bank will have helped the markets sidestep some of the economic damage that can be done when lending and credit seize up for long periods of time. And it will have done so without diminishing its inflation-fighting capabilities by cutting the fed funds rate.

The discount window applies to the short-term rate at which the Fed lends to banks and other depository institutions. The more heralded fed funds rate is used when banks lend to each other. The risks to inflation that have kept the Fed holding that rate steady for a year are still in place.

Headline inflation is still high, and labor costs have been rising. More importantly, aggressive rate cuts could further deteriorate the value of the dollar, which fell modestly vs. the yen and, more significantly, against the euro in response to Friday's Fed action.

Those whose homes were foreclosed on may not see any benefit from a Fed funds rate cut at this point, but they'd certainly suffer from a long period of higher inflation. MKM Partners' chief economist Michael Darda noted that after the Fed funds rate cuts following the 1987 stock market crash, the economy had to cope with four years of uncomfortably high core inflation that included a recession.

Investors will be able to tell if the knot is looser by watching the credit markets that stopped working due to the spillover from subprime mortgages and structured credit. If borrowing gets a little easier for everyone from affluent second-home buyers with good credit to institutions that finance their operations through the commercial paper market, we'll know the markets are on the mend, at least for the time being.

If not, the Fed gave itself the leeway to cut the fed funds rate by acknowledging more risk to the growth side of its current economic forecast. In the statement accompanying its discount rate cut, the Fed said, "downside risks to growth have increased appreciably."

The stock market, which was dramatically in what technicians call oversold territory, rallied back from a 10% correction mark Thursday and again Friday in response to the Fed. The Dow Jones Industrial Average soared 233 points Friday, though it still ended the week lower by 1.2%.

The Economic Cycle Research Institute's weekly index of leading indicators reveals the economy's outlook has dimmed. Its weekly growth rate dropped to 4.2 from 5.1 last week, and down from its June peak this year of 6.9.

But the group, which was successful in predicting the last recession, says the decline in its indicator is largely "because of market turmoil," and that "real economic variables" are balancing out the market's plunge.

"This is not a recessionary scenario," says Anirvan Banerji, director of research for the ECRI.