The Dow Jones Industrial Average ended off 96.24 points, or 2.4 percent, at 3,871.42. It was the blue chip barometer's biggest decline since it fell 120 points on 15 November 1991.
Traders and analysts said the stock market was vulnerable to a sharp correction after the Dow gained 6 per cent in January. The selling was triggered by the Fed, which yesterday formally moved to send short-term interest rates higher for the first time in five years. The action is designed to nip any resurgence of inflation in the bud but will quickly lead to an increase in borrowing rates for businesses and consumers.
In a most unusual step, the Fed publicly announced the decision taken by this week's closed-door meeting of the central bank's key monetary policy body, the Federal Open Market Committee. Analysts were interpreting yesterday's market developments as a sign the benchmark federal funds target rate, unchanged since late 1992, will rise a quarter point to 3.25 per cent.
Although a rise in rates in the near future had been taken for granted, the Fed's frank acknowledgment of what it was about caught the markets completely off guard. Predictably the dollar strengthened, while bond and stock prices tumbled.
Worries over higher US rates pushed London shares down slightly. The FT-SE 100 index shed 16.1 points to close at 3475.4. But further losses are expected next week. The 30-year US Treasury bond plunged, pushing up its yield to 6.36 per cent.
The Fed decision pushed the dollar up sharply. The pound fell 1.33 cents to dollars 1.4837 and the dollar climbed by 1.80 pfennigs to a London close of DM1.7505. Later in New York, the dollar climbed to a two and a half year high of DM1.7610.
A written statement by the Fed chairman, Alan Greenspan, said it had taken the long awaited step to 'sustain and enhance the economic expansion under way'. It had been announced 'to avoid any misunderstanding of the committee's purpose' in initiating the first firming of reserve market conditions since early 1989.
Since then the central bank has nudged short-term rates down to their lowest point in three decades, to help the country out of recession and allow banks to rebuild their financial strength after the buffeting of the late 1980s and early 1990s.
Now, however, recovery looks set fair, with growth of at least 3 per cent likely for 1994 and beyond. Inflation has become the top priority.
Yesterday's unemployment figures sealed the Fed's determination to apply a gentle squeeze to the monetary brakes. Calculated on a new basis, they showed a rise from 6.4 per cent in December to 6.7 per cent in January.
Although the increase in non-farm payrolls was a modest 62,000, the overall jobless rise was smaller than expected. Most significant, average hourly earnings showed their biggest one-month advance since 1983, a further hint that inflationary pressures are building anew.
The new policy's impact will be felt initially by short-term lenders and borrowers. Bank deposit rates are expected to rise, as are credit card interest rates, and the cost of short- term borrowings by business. However, analysts believe the current commercial bank prime rate of 6 per cent will remain for a while, perhaps until the Fed pushes rates a little further ahead, perhaps in mid-year.
The astonishing openness of Mr Greenspan was plainly intended to prevent damaging leaks about what had been decided - normally not announced for several weeks.
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