Stocks Jump on Fed's Prediction for Inflation
Bank Expects Prices to Level Off, Holds Rate Steady

By Heather Landy and Neil Irwin
Washington Post Staff Writers
Wednesday, August 6, 2008

NEW YORK, Aug. 5 -- The Dow Jones industrial average jumped 2.9 percent Tuesday as investors drew confidence from a continued decline in oil prices and from the Federal Reserve's prediction that inflation would level off.

The Fed left interest rates unchanged and indicated that although it is worried about the slumping economy, it will be vigilant about inflation.

"Everyone is so focused on commodity prices, so the fact that oil prices have continued their multiple-day decline is taking a lot of fear out of the marketplace and giving stocks a good reason to bounce," said Wendell Perkins, chief investment officer of Optique Capital Management, which oversees $1.6 billion. Meanwhile, the central bank's concern about economic growth "is good news in that it suggests the Fed will have to take its time before it raises interest rates," he added.

The Dow posted its biggest gain in four months, climbing 331.62, to 11,615.77. The Standard & Poor's 500-stock index and the Nasdaq composite index also posted gains, with each rising more than 2.8 percent.

Ron Sloan, manager of the $5 billion Aim Charter Fund in San Francisco, said he still had concerns about inflation and suspected that Tuesday's rally would not mark a turning point in the long-term performance of stocks.

"You've had a couple of 200-plus point moves [upward] in the last months that led to nothing, and then you had a few 200-plus point declines that led to nothing," Sloan said. But "the prospect of a rate increase is perhaps a little bit farther back on the burner than some people thought," he said.

Tuesday's rally was broad-based, with gains posted by 29 of the 30 blue-chip stocks in the Dow and with all 10 industries represented in the S&P 500 ending the day higher. The Dow's only decliner, oil-producer Chevron, fell 31 cents, to $82.49.

Procter & Gamble shares rose $2.15, to $67.97, as the company beat quarterly profit estimates. Price increases on many of the household products sold by the company helped offset higher manufacturing and packaging costs stemming from the rise in oil.

Lehman Brothers shares jumped $2.30, to $20.24, after CNBC, citing unnamed sources, reported that the embattled investment bank might try to sell its investment-management division.

Shares of J.P. Morgan Chase, Citigroup and Merrill Lynch also rose as stockholders, whipsawed earlier this year by the still-rippling credit crunch, took solace in the signals coming from the Fed.

The central bank's policymaking committee left the federal funds rate, at which banks lend to one another, at 2 percent. The rate ultimately affects what consumers pay on credit cards, car loans and adjustable-rate mortgages, and what businesses pay to borrow money to expand.

"Until the liquidity crunch is under control, the Fed really can't raise interest rates," said David Dreman, chairman of Dreman Value Management, which oversees $15 billion in Jersey City, N.J. "And so we have to block out the concerns about inflation and focus entirely on the liquidity crisis, temporarily."

The central bank also held the federal funds rate steady at its late June meeting, following steep cuts in the winter and spring meant to prevent a deep and prolonged recession. The decision to stay on hold reflects a difficult situation in which growth is weak yet prices are rising. Those pressures effectively act as counterweights, leading the Fed to stand pat.

"They can't commit to dealing with one of these ailments without making one of the other ones worse," said Richard Yamarone, chief economist at Argus Research. "There's nothing the Fed can do, so they're going to stay where they are."

The Fed made relatively subtle changes to its statement following its June 24-25 meeting, backing away from a statement that risks to growth "appear to have diminished somewhat." Since June, strains in the financial markets have returned, and the economy has come to look weaker.

But there has been good news since then, too, as prices for oil and other commodities have dropped. The Fed statement said that it expected prices to level off but that the "inflation outlook remains highly uncertain."

That can be taken to mean that the Fed would be willing to raise rates if there were a new spike in oil and other commodity prices or further big drops in the value of the dollar.

"Although downside risks to growth remain, the upside risks to inflation are also of significant concern," the statement said, a subtle indication that it is more likely to raise rates in the months ahead than to cut them further.

There was, for the eighth straight meeting, dissent on the committee. Richard W. Fisher, president of the Federal Reserve Bank of Dallas, voted against leaving rates unchanged, preferring to raise them. He also dissented in June, arguing that the Fed should take a more aggressive line to combat inflation.

"Fisher has been dissenting for a long time, but his opinion is clearly the minority view," said Arun Raha, a senior economist with Swiss Re. "They're signaling they're going to hold rates constant for a while."

Also yesterday, a new Fed governor, Elizabeth A. Duke, was sworn in after being confirmed by the Senate earlier this summer. A former executive of Portsmouth, Va.-based TowneBank, Duke has also been chairman of the American Bankers Association and an executive with Wachovia.

Duke is expected to play a major part in the Fed's role supervising banks. In her first meeting, she voted with the majority to leave the federal funds rate unchanged.