The Federal Reserve made a bold move yesterday afternoon by reducing its target for the federal funds rate to a range of between zero percent and 0.25 percent — the lowest range since the Fed began targeting bank overnight lending rates during the late 1990s.
In response to the Fed’s unprecedented move, stocks rocketed higher on Tuesday, with the Dow Jones Industrial Average advancing 360 points (4.2 percent) compared to the prior day’s close.
Although I expect stocks to pull back a bit during the next few days, my research indicates that equity prices will continue to trend higher during the months ahead. That forecast is based primarily on the following factors: Both short-term and long-term interest rates are currently at historic lows as a result of the Federal Reserve’s aggressive monetary actions over the past six months. President-elect Barack Obama has assured Americans that he and the U.S. Congress will enact a government spending program during the coming year that will be "of a size and scope that is necessary to get this economy back on track" and "significant enough that it really gives a jolt to the economy." The housing market is showing signs of bottoming. Sales of existing homes are trending higher over the past four months; inventories of new homes fell to their lowest level since mid-2004; and the 30-year conventional mortgage rate fell last week to its lowest level (5.47 percent) since March 2004. (Mortgage rates will likely continue to decline given that the Federal Reserve recently stated that it plans to purchase up to $500 billion of mortgage securities on the open market). The gap between yields on bonds and yields on equities is currently the widest since at least 1962 (the earliest date for which data is available), which suggests that investors will likely return in droves to the equities market as soon as they see more signs that the U.S. economy is stabilizing.
In its statement to the press regarding yesterday’s interest rates cut, the Fed said that it will “employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability” and that it will maintain short-term interest rates at low levels “for some time.”
Additionally, the Fed stated that “early next year” it will “facilitate the extension of credit to households and small businesses.” That statement suggests that even if banks continue to tighten their lending standards, the Fed will implement actions to increase lending.
Meanwhile, numerous other developments indicate that the current recession will end by next June and that the U.S. economy will expand rapidly during the third quarter of 2009. I plan to discuss some of those developments in my next article in this space.
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