Fed poised to slash rates even as jitters ease

U.S. Federal Reserve policy-makers opened a meeting on Tuesday that was expected to lead to the biggest one-day cut in interest rates since 1982, as two major Wall Street firms provided some relief to markets with better-than-expected earnings.

Goldman Sachs Group Inc and Lehman Brothers Holdings Inc reported that profits fell less sharply than feared, boosting U.S. stocks ahead of an expected one percentage point cut in the Fed's base interest rate. The absence of shocks from two of the four biggest investment banks calmed nervous investors only two days after the fifth-biggest U.S. investment bank, Bear Stearns was forced to sell itself to JPMorgan Chase & Co in a rescue deal engineered by the Fed.

U.S. stocks powered higher at the open and the Dow Jones industrial average <.DJI> and other major indices were up more than 2 percent by mid-morning. Interest-rate futures prices showed dealers were scaling back bets on a full-point rate cut, although it was still seen as the most likely outcome.

"Some of the relatively poor expectations for earnings in the financials have been exceeded," said Subodh Kumar, chief investment strategist at Subodh Kumar & Associates in Toronto. He added that "there's more confidence about the Fed. Perceptions about how involved the Fed is and how successful it will be have changed for the better." Goldman Sachs, which has largely avoided the mortgage-related losses that have plagued much of Wall Street, said first-quarter earnings fell by half after the largest U.S. investment bank recorded steep losses on corporate loans and other assets. Yet the results exceeded expectations, which had been lowered in recent weeks. Lehman Brothers, whose shares have been pummeled in recent days on concern it is the most vulnerable to troubled mortgages and leveraged loans next to Bear Stearns, suffered a sharp fall in bond trading revenue but benefited from rising merger advisory revenue.

The Fed has taken a number of radical steps in recent days to stabilize the financial system and combat the risk of a severe recession. Many economists believe the U.S. economy is already in recession, and U.S. Treasury Secretary Henry Paulson on Tuesday conceded the economy was in "sharp decline."

The Fed has already cut overnight rates by 2.25 percentage points, to 3 percent, since mid-September as a rise in defaults on subprime mortgages has escalated into a financial crisis. It is expected to add to its series of moves to contain the crisis with its biggest rate cut in 26 years. Since credit market turmoil first erupted in August, the U.S. central bank has narrowed the gap between the discount rate -- the rate at which it lends directly to banks -- and the overnight federal funds rate, the Fed's main policy tool, from three-quarters of a percentage point to a quarter point.

It has also unleashed a barrage of other unorthodox steps to provide liquidity, including $30 billion in financing to enable JPMorgan to buy Bear Stearns. In addition, it set up a new program to provide cash to a wider range of big financial firms through loans at the Fed's discount window.

Against the market upheaval, fears that a seizing up of the financial system could plunge the U.S. economy into deep recession have overtaken worries about inflation fueled by high oil and commodity prices. The latest troubling inflation sign came on Tuesday with a report that showed U.S. producer prices, excluding volatile food and energy costs, shot up 0.5 percent last month, the biggest jump since November 2006.

A separate report, however, showed another drop in housing starts and a big slump in permits for future building. "With the recent market turbulence, those inflation concerns are now taking a backseat, and the (Fed) has to think about the action that not only is appropriately aligned with the forecast, but that also supports financial markets at a time of extraordinary turbulence and systemic risk," Laurence Meyer, a former fed governor now with forecasting firm Macroeconomic Advisers, said in a note to clients.

The Fed has focused its efforts in recent days on making funds available to banks and Wall Street firms, offering hundreds of billions of dollars in auctions and credit to thaw frozen credit markets. Policy-makers may have hoped that the recently announced emergency actions would remove the need for a deep interest rate cut. However, officials will have to take stock of gloomy data on hiring, factory output and retail sales.