Stocks Rally as Fed Holds Steady

The central bank's statements on growth and inflation eased some worries about rate hikes in the months ahead. Oil fell below $120 per barrel

Watch the Video…

The Federal Reserve warned of weak economic growth and the threat of inflation Tuesday, and the stock market loved it.

There was little surprise in the Fed's decision to hold the federal funds rate at 2%, but something about the afternoon news still cheered investors. Stocks rallied in the morning, supported by better-than-expected economic data and falling oil prices, but rose even higher after the Fed issued its statement.

Traders may have been relieved by the growing notion that the Fed won't be raising interest rates anytime soon. "The Federal Reserve said little new," said Marc Chandler of Brown Brothers Harriman. The statement, however, "gives little reason to expect a [September] rate hike, which we previously had thought was possible."

On Tuesday, the Dow Jones industrial average rose 331.62 points, or 2.94%, to 11,615.77. The broader S&P 500 index added 35.87 points, or 2.87%, to 1,284.88. The tech-heavy Nasdaq composite index rose 64.27 points, or 2.81%, to 2,349.83.

On the New York Stock Exchange, 24 stocks moved higher for every 8 in negative territory. On the Nasdaq, the ratio was 19 to 9 positive.

Oil prices fell below $120 per barrel to its lowest price since early May. On the NYMEX, crude oil for September delivery fell $2.24 to $119.17 per barrel. The U.S. average for a gallon of gasoline fell 1 cent to $3.871.

Also helping stocks rally Tuesday morning was better-than-expected reading from the service sector. The U.S. ISM services composite index improved to 49.5 in July after falling over 3 points to 48.2 in June. The general activity index was little changed at 49.6 from 49.9. The employment component rose to 47.1 after hitting a record low at 43.8 in June. New orders index slipped to 47.9 from 48.6. New export orders slid to 47.9 from 52.0, back below 50 for the first time since February. Prices paid fell to 80.8 from the record 84.5 in June.

Fed-watchers carefully read the Fed's statement for clues to future policy moves. Some think growing inflation pressures will eventually push the Fed toward higher interest rates, with the Fed future market expecting a rate hike in December. But the statement barely changed from last month's meeting.

"While the Committee is undoubtedly concerned about inflation, the statement points to an expected moderation in inflation and implicitly notes the recent fall in energy and some commodity prices," wrote John Ryding of RDQ Economics. At the same time, the Fed apparently expects several quarters of weak economic activity, translating into higher unemployment into 2009, added Ryding, who believes the Fed won't change interest rates until next year.

In its statement, the central bank noted that economic activity expanded in the second quarter, partly reflecting growth in consumer spending and exports. But “labor markets have softened further and financial markets remain under considerable stress.” The Fed added that tight credit conditions, the ongoing housing contraction, and elevated energy prices “are likely to weigh on economic growth over the next few quarters.”

“Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth,” the Fed said.

The Fed’s release stated that inflation has been high, “spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated.” The Fed expects inflation to moderate later this year and next year, but the inflation outlook remains “highly uncertain."

The Fed concluded: “Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.”

The Fed meeting was again marked by dissent, with Dallas Fed president Richard Fisher breaking from the FOMC ranks to vote for a rate hike.