The Federal Reserve did not raise interest rates Tuesday but switched to a tightening bias that could spell more gloom for bank stocks.
Bank stocks have been reeling since May and were down 15% in the third quarter alone. Many analysts attributed the downward pressure to uncertainty about whether the Fed would raise rates. Tuesday's action by the Fed keeps this sword of Damocles above the market's head.
The news, released at 2:15 p.m., erased strong bank stock gains made earlier Tuesday, and in less than five minutes the Standard & Poor's bank stock index fell 1.3%, ending the day down 0.6%.
The Nasdaq bank stock index fell 0.1% for the day.
"The Fed has thrown the uncertainty wrench into the market until it meets again in November," said Gerard M. Cronin, an analyst for McDonald Investments, a KeyCorp subsidiary. "Banks will be trading off every economic report that comes out now."
Patrick Flaherty, an associate economist at Fleet Boston Corp., said there was a 30% to 40% chance the Fed would raise rates in November. "They will raise rates if the data say its necessary."
Though the Federal Reserve's Open Market Committee decided against raising the discount or federal funds rates, the switch to a tightening bias took some by surprise, as evidenced by the steep declines in the markets. The Dow Jones industrial average plummeted more than 200 points from its high for the day of 10,509.19, then rallied late to close down just 0.64 for the day, at 10,400.59.
In a written statement, the Fed said the FOMC has "adopted a directive that was biased toward a possible firming of policy going forward." It said productivity growth has been helping keep prices down, but that the committee will have to "be especially alert in the months ahead" to the dangers of inflation.
The decision not to raise interest rates on Tuesday was widely expected by the markets, and had been reflected by the buoyancy of bank and financial company stocks on Monday and Tuesday. What had been uncertain was whether the Open Market Committee would change its bias to tightening, from neutral.
Tuesday was viewed by many observers as the Fed's last shot at raising rates until next year. With one more meeting of the FOMC scheduled for this year, Nov. 16, many market watchers expected Federal Reserve Chairman Alan Greenspan to shy from raising rates so close to yearend. With year-2000 compliance issues looming, the Fed will want to ensure there will be plenty of cash on hand to deal with any potential liquidity drains, they said.
At yearend "the Fed would prefer to leave as much liquidity in the system as possible," said Richard Schwartz, a fixed-income portfolio manager at New York Life Asset Management in Parsippany, N.J.
In part, the markets sensed that the Fed would stand pat as the meeting neared, because recent economic reports failed to paint a strong inflationary picture. Indicators such as the consumer price index, the producer price index, and the employment report failed to show increases significant enough to prompt Fed action.
Also, observers noted that Federal Reserve officials, in speeches recently delivered nationwide, did not hint of imminent rate hike. Prevailing sentiment was that the Fed's current approach is to prepare the markets for a hike so that when it comes, investors will not be shocked and will be more likely to act with restraint.
The central bank's move to a tightening bias "is a sign that the Fed will raise rates in November," said Joel L. Naroff, chief economist at Commerce Bancorp in Cherry Hill, N.J. "Right now bank stock investors and the markets are coming to the conclusion that additional Fed action is inevitable. I think that is a very high possiblity."