Emergency rate cut may show the Fed panicked

CHICAGO (Reuters) - The Federal Reserve's huge emergency interest rate cut on Tuesday smacked of panic from a central bank spooked by a global markets rout, and may have exposed deep concerns about the health of the U.S. economy.

Just a week before a scheduled two-day policy meeting, the Fed, the U.S. central bank, slashed rates as a sell-off in global equities extended into a second day and Wall Street looked poised for steep losses after a long holiday weekend.

The early-morning strike fueled worries from Fed watchers that the bank is too market-driven and sees itself as behind the curve in shoring up U.S. economic growth.

But it also may have revealed a view by the Fed that a bold stroke would prove most effective.

"My God, the Federal Reserve couldn't wait a week for their meeting? These guys are unbelievably reactive," said Jeffrey Gundlach, chief investment officer of TCW Group in Los Angeles, which manages assets worth $160 billion.

"Clearly they were forced by the markets into this move, which only impairs their credibility," Gundlach said.

Markets took Tuesday's cut in the Fed's benchmark lending rate, to 3.50 percent from 4.25 percent, as an interim step, with another move likely next week. After the previous four intra-meeting rate cuts since 1994, the Fed has cut rates again at the following monetary policy meeting.

The Fed's emergency conference call on Monday came as share markets around the globe were enduring a savaging while the U.S. market was closed for the Martin Luther King Jr. holiday.

The cut was "obviously triggered by a stock market fall, regardless of the statement's talk about 'increasing downside risks to growth,'" said Gabriel Stein, an economist at Lombard Street Research in London.

By moving abruptly, the Fed took the gamble of exposing the extent of its own concerns about the deterioration in financial markets, and hinting it knows of even worse news waiting in the wings.

"If you get told you're going into a recession ... there's a self-fulfilling prophecy nature of this, which I think we are at," said Catherine Mann, a former Fed official and a member of the White House Council of Economic Advisers. Mann is now a professor at Brandeis University's business school.

AIN'T EVER SATISFIED

Panic aside, the Fed seemed to be embracing theories espoused by Chairman Ben Bernanke about the beneficial impact of surprise rate moves on asset prices.

In a speech in 2003 when a Fed Board governor, Bernanke cited evidence that easier monetary policy that took markets by surprise has beneficial effects on asset prices.

"Each basis point of surprise monetary easing leads to about a 5-basis-point increase in the value of stocks," Bernanke said at the time.

Fed Governor Frederic Mishkin, who was absent for the Monday night vote, has also advocated a policy of larger, preemptive rate moves rather than a more gradualist approach.

Although a 75-basis-point cut had been widely discussed, by Friday's close options contracts still priced a 43 percent chance that the rate-setting Federal Open Market Committee would lower rates by only 50 basis points this month.

"Being more assertive when the market needs it is a plus in the action today," said former Fed Governor Susan Bies.

Upon hearing of the Fed's move, futures traders immediately priced in another big move at the Fed's January 29-30 meeting.

"Today's decision ... is a declaration of a state of emergency for the U.S. markets and the economy," said Ashraf Laidi, chief FX strategist at CMC Markets US in New York.

Futures contracts now show a 72 percent implied chance of another 50 basis points in cuts on January 30. Dealers expect the Fed to slash benchmark short-term rates to about 2.25 percent by mid-year, which would bring the total reduction over 10 months to 3 percentage points.

"The Fed is responding to an economy and financial system going into cardiac arrest. This will require emergency-room-style policy action from the Fed," said Scott Anderson, senior economist at Wells Fargo in Minneapolis.

(With additional reporting by Mark Felsenthal in Washington and Jennifer Ablan in New York; Editing by Frank McGurty)