FED SHIFTS OPTIONS AS RATE CUT FAILS TO CHEER MARKETS

But yesterday's moves, at the low end of Wall Street's hopes, disappointed investors, who had looked to the Fed to do more to thaw frozen credit markets. The Dow Jones Industrial Average fell sharply, undoing about a third of the run-up in stocks triggered in late November when top Fed officials first publicly signaled that another rate cut was likely. The blue-chip average ended the day at 13432.77, down 294.26 points, or 2.1%. (See related article.)

The Fed lowered its target for the federal-funds rate, charged on overnight loans between banks, by a quarter percentage point to 4.25%. It also cut the discount rate, at which it lends directly to banks, by the same amount, to 4.75%.

Fed officials, however, continue to consider ways of using various tools -- including the discount rate -- to combat banks' unwillingness to lend even to each other, which they view as a threat to economic growth. The central bank could take action within days.

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A variety of steps, widely discussed in the markets, are likely to be on the table, including another cut in the discount rate, longer-term loans to money-market dealers, easier collateral rules for loans from the Fed, and other steps last taken in 1999 to alleviate funding pressures ahead of the year 2000, when many feared a "Y2K" computer bug would disrupt markets and create economic havoc.

Changes in the discount rate can be made by the Fed board in Washington without the approval of the entire 17-member policy-making Federal Open Market Committee, which sets the federal-funds rate target.

Some on Wall Street yesterday criticized the Fed's actions so far as inadequate. "From talking to clients and traders, there is in their view no question the Fed has fallen way behind the curve," said David Greenlaw, economist at Morgan Stanley. "There's a growing sense the Fed doesn't get it."

Markets believe a weakening economy will force the Fed to cut rates even more than they expected before yesterday, Mr. Greenlaw said. Futures markets anticipate another cut in January and a federal-funds rate of 3.25% by next fall.

In its statement yesterday, the Fed said that its quarter-point rate cut, which pushed the federal-funds rate a full percentage point below where it stood in early August, "should help promote moderate growth over time."

In October, the central bank said the risks of weaker growth and of higher inflation were roughly balanced, signaling it didn't expect to cut rates again. Yesterday, the Fed declined to give an explicit indication of its next move. It said it will assess financial and other developments and "act as needed." The Fed's language left its options open for its next meeting in late January.

The FOMC's 10 voting members approved the rate cut 9-1. Federal Reserve Bank of Boston President Eric Rosengren dissented in favor of a sharper, half-point cut. One FOMC member also dissented in October, but in favor of no rate cut. The shift in the dissents, from wanting less rate cutting to wanting more, shows the turn toward pessimism at the Fed.

"Economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending," the Fed said yesterday. "Moreover, strains in financial markets have increased in recent weeks."

Unlike the previous two rate cuts, yesterday's wasn't portrayed as "insurance" against improbable but potentially damaging economic scenarios. That suggests Fed officials view the economy as weaker than they expected as recently as late October.

Corporate executives are also signaling a more downbeat outlook. "I'm not going to put a happy face on this. Consumers are going to be a challenge in 2008," General Electric Co. Chief Executive Jeffrey Immelt told investors yesterday. But global growth is "as strong as ever," he added.

When Fed policy makers met in late October, financial markets were in better shape than they had been in August, and the economy had just posted a strong third-quarter performance. They chose to cut rates by a quarter point and concluded that would likely be enough.

But in subsequent weeks, markets reversed course as big losses tied to soured mortgage-related investments cut into the capital of major banks and other financial institutions, limiting their ability to lend. Fed Chairman Ben Bernanke and Vice Chairman Donald Kohn signaled their increased concern in speeches in late November, foreshadowing yesterday's rate cut.

Even so, investors, who have persistently had a gloomier outlook than the Fed, were disappointed the Fed didn't cut rates more or signal greater willingness to do so. "Well, the boys blew it again. You wonder which economy they are looking at and what it is they are thinking about," said Alfred Kugel, Chicago-based chief investment strategist for investment-management firm Atlantic Trust of Atlanta.

Bond prices shot up yesterday and yields, which move in the opposite direction, fell sharply. The 10-year Treasury note's yield dropped to 3.97% from 4.1% just before the announcement, while the two-year note's yield, which is especially sensitive to expectations of Fed action, fell to 2.92% from 3.13%. Yields on corporate bonds rose relative to Treasurys.

Major banks, meanwhile, lowered their prime lending rates, the benchmark for many consumer and business loan rates, to 7.25% from 7.5%.

The Fed has found it especially difficult to discern the economy's path and thus the right level for rates because the main threat facing the economy is the reluctance of banks and investors to lend to home buyers, businesses and consumers. That's harder to measure than the things that usually drive the business cycle -- such as profits, inventories, employment and the Fed's own interest-rate actions.

Brian Sack, an economist at Macroeconomic Advisers LLC, said that in 2001 the major shock to the economy was the stock market. "We have a better shot at trying to calibrate those wealth effects, whereas the credit turmoil has many dimensions to it. Frankly it's hard to assess how much economic restraint you get from those various dimensions."

In the past month, data on the so-called real economy have been soft but not dramatically so. Macroeconomic Advisers said yesterday it now expects the economy to shrink marginally during the current quarter, then grow at a 1.8% annual rate in the first quarter of 2008.

On the other hand, credit markets have tightened sharply. Since Oct. 31, the yields on securities backed by auto loans have jumped to 6.3% from 5.4%, while yields on securities backed by home-equity loans have jumped to 7.7% from 6.6%, according to J.P. Morgan Chase & Co. Rates on "jumbo" mortgages -- those larger than $417,000 -- are around 6.9%, up from 6.6%. The London interbank offered rate, the rate banks charge each other for three-month loans in the offshore market -- is a full percentage point above the expected federal-funds rate; it is typically less than a tenth of a point higher.

There isn't yet evidence these higher rates have significantly bit into consumer spending, outside of housing, and the rates could drop after year-end funding pressures ease. But investors generally don't expect that to happen.

A survey by Macroeconomic Advisers of 55 clients, mostly hedge funds and other sophisticated investors, found most expect little retracement of the wide spreads between yields on risky debt and Treasury yields by next year, and most expect banks to curtail lending. "The possibility of a widespread pullback in credit availability is a significant risk to the outlook," the firm said.