The Federal Reserve left interest rates unchanged Tuesday, apparently hoping that staying put will help calm turbulent markets following a period of seismic upheaval on Wall Street.
But the central bank left open the likelihood that interest rates could be cut at future Fed meetings later this year.
Consider the events of the past few days: investment bank Lehman Brothers collapsed into bankruptcy; Merrill Lynch (MER: 20.73, +3.67, +21.51%), fearing a similar fate, was absorbed by Bank of America (BAC: 28.30, +1.75, +6.59%); and insurance giant American International Group (AIG: 3.40, -1.36, -28.57%) teetered at the abyss.
In response, the Dow Jones Industrial Average plunged 504 points on Monday, its biggest drop since immediately after the terrorist attacks of Sept. 11, 2001.
The historic shifting of the landscape left economists and investors mixed on what the Fed might do. Ahead of Tuesday's announcement, some thought action needed to be taken, while others believed the Fed would maintain the status quo.
Tuesday's decision not to act came as AIG struggled with mounting pressures after major credit rating agencies issued downgrades for the company.
While the Fed may not have acted, a significantly different mood had emerged in terms of what future direction the Fed will take. In the wake of the events of the past few days, market watchers now believe the Fed is poised to cut rates further before the end of year, rather than raise them.
Ben Garber, an economist with Moody's Analytics, said prior to Tuesday's announcement that the shift in the financial landscape had altered the mood of the markets and that he supported some decisive action--a half point cut, in fact.
Garber noted that the risk of inflation, which rises as interest rates are cut, is lower now than earlier this summer, when the price of oil was surging to record highs, leaving the door open for cuts.
The Fed started a year ago with an aggressive effort to cut interest rates, pushing the federal funds rate down from 5.25% to 2%, where it has been since the Fed's last rate cut in April.
Douglas Smith, an economist with Standard Charter Bank, said future rate cuts might offer investors psychological benefits.
"The psychology in the markets is so awful, a rate cut may help to boost confidence," he said.
Even before Fed officials began meeting in Washington on interest rates, the Federal Reserve Bank of New York moved aggressively to try to bolster confidence by injecting $70 billion into the financial system to provide additional resources for banks.
In addition, the Fed announced on Sunday that it was expanding its efforts to supply more cash to the financial system as a way of helping other financial firms that might be facing problems in the wake of the Lehman bankruptcy filing.
But many economists believed those measures may not be enough to calm markets.
Another factor that might influence the Fed to cut at a future meeting is the recent jump in unemployment, which surged in August to a five-year high of 6.1% as companies shed another 85,000 jobs.
On the inflation front, the central bank is likely eyeing recent news showing a sharp fall in oil prices with crude closing below $100 per barrel on Monday for the first time in six months.
That, combined with the historic turbulence shaking the financial markets, could push the Fed to lower rates.
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