The central bank said Wednesday morning it would make an intermeeting cut in the target federal funds rate of half a percentage point to 1.5%. Five other central banks, including the European Central Bank, also slashed key interest rates.

The Federal Reserve cited a dramatic slowdown in economic activity as a result of “financial market turmoil,” coupled with moderating inflationary pressures, as the key reason for its decision.

Fed fund futures, bets on which way interest rates will move, are pricing in a 100% chance that the Fed will cut an additional quarter point to 1.25% at its October meeting. The futures market clearly believes such a rate cut is inevitable. 
Stock-index futures declined after the announcement, but stocks see-sawed between red and black in the morning as the markets digested the move, along with other economic data.  

However, fears still resound on Wall Street that the Fed’s bag of tricks is now empty after the most recent rate cut. But the Fed has a lot of power to make continued rate cuts, according to Josh Feinman, Chief Economist with Deutsche Bank Advisors.

“Obviously, they could cut rates more, and they may do so,” said Feinman. “I can see the funds rate going down to 1% or something, but what I think their focus is going to be here is increasing the provisions of liquidity, they are going to put the pedal to metal in terms of expanding its balance sheet.”

Another option the Fed may take is to make capital injections, according to Diane Swonk, Chief Economist for Meisrow Financial in Chicago.

“There are multiple tools the Fed can use to inject massive amounts of liquidity into the system, because they now possess more than $3 trillion in lending authority,” Swonk said.

Feiman said he could see the Fed’s balance sheet doubling in size over the next few months, and that the agency has the capacity to expand as much as they need. Over the next few months, the fed may circumvent the banking system altogether, lending directly through the purchase of commercial paper. “They are going to roll out the heavy artillery,” said Feinman.

The current rate cut will help the market, but it will take time because the credit crunch has been so intense and pervasive, said Feinman. House prices are still on the decline, and probably won’t hit bottom until the first half of next year. Consumer confidence has taken a major hit, and the economy likely won’t show serious improvement until the latter half of 2009 and the early part of 2010, though it may take longer, Feinman said.

The bankruptcy of investment bank Lehman Brothers fueled a worldwide domino effect that caused credit to seize up as market participants feared lending to each other. This decreased level of liquidity made it difficult for businesses to obtain much-needed capital, which in turn caused economic activity outside the financial sector to slow.

The Federal Reserve has taken dramatic actions in the last two days to unclog the system. On Monday, the Fed announced it would pay interest on reserves, which set the stage for the Fed to inject massive amounts of liquidity into the market. The central bank also increased lending to investment banks at its Term Auction Facility from $85 billion to $150 billion.

The following day, the Fed announced the creation of the Commercial Paper Funding Facility, which allows the Fed to purchase substantial quantities of difficult-to-value securities that have been plaguing credit markets.

The intended results of the actions have yet to come to fruition, to some extent. Interbank lending in the overnight market is still sluggish, and institutions are borrowing money from the Federal Reserve at alarming rates. Indeed, the Federal Reserve accepted $138 billion in loan applications from investment banks just two days ago.

“The problem is even worse than just a global market selloff. In the last few days, investors around the world have been shifting money into government bills and notes from all other forms of assets,” Carl Weinberg, chief economist at High Frequency Economics, said in a research note. “When everyone moves into cash, banks are no longer effective intermediaries in the monetary system. They are no longer lending, so interest rates no longer affect the economy.”

On the bright side, our government has made ever effort to “sweeten the pot” during this current downturn, and have done everything in opposite to the way it was done during the Great Depression, according to Swonk. “Our financial authorities are now doing the right things, they are planting the seeds, and now we just have to wait for the garden to grow,” she said.

“It’s okay to say things are going to get better,” Swonk said. “We have set the conditions, and the ball is rolling to get back on track.”