By  on August 20, 2007

Stocks closed higher Friday after the Federal Reserve cut its discount rate half of a percentage point after weeks of market volatility due to credit market uncertainties on cost-of-borrowing increases.

The Fed temporarily reduced its discount window's primary credit rate to 5.75 percent and announced term financing for up to 30 days, renewable by the borrower. The Fed's discount window allows eligible institutions to borrow money, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions.

"Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward," the Federal Reserve said in a statement. "In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably."

The move was one week after the Fed began to add liquidity to the credit sector to maintain the "orderly functioning" of the financial markets after intense volatility during the past month. The fluctuations were driven by the repricing of risk in the credit markets after foreclosures on subprime mortgages expanded.

Friday, the Fed said it is keeping watch over the situation and is prepared to "act as needed" to ward off negative effects on the economy from market disruptions.

As a result of the Fed's action, the Dow Jones Industrial Average closed up 1.8 percent to 13,079.08, the S&P 500 gained 2.5 percent to 1,445.94, the New York Stock Exchange added 2.5 percent to 9,316 and the Nasdaq climbed 2.2 percent to 2,505.03.

Retail stocks posted significant gains — the S&P Retail Index rose 2.4 percent to 463.1. Retail investors have worried whether a tightening in the credit market would affect consumers' ability to spend money.

Brean Murray Carret & Co. analyst Eric Beder called the Fed's action a "nice positive" for retail stocks in the long term, but he does not expect the rate cut to have an immediate effect on the sector.

"The Fed is not going to let the market melt down," said Beder.Beder said consumers will start to open their pocketbooks over the next several months once they see other macro factors, such as housing, food and gas costs, stabilize or fall.

In the short term, Beder said retail investors are focused on back-to-school shopping and second-quarter earnings results — which he expects to be "very lackluster" due to potential misses and conservative guidance going forward. Many speciality retailers, including companies under Beder's coverage such as The Wet Seal Inc., New York & Co. Inc., Wilsons The Leather Experts Inc., Bebe Stores Inc. and Aéropostale Inc., are slated to report earnings this week.

American Eagle Outfitters Inc., a Wall Street darling over the last several quarters for its double-digit same-store sales growth and increasing operating margins, is scheduled to report Tuesday.

"The big question on investors' minds is whether the company can maintain its historically high operating margin of 21 percent achieved in 2006, while investing in future growth," said Telsey Advisory Group's Dana Telsey, chief research officer, in a research note. "For this to occur, it is essential that lower product costs, coupled with same-store sales gains near the midsingle-digit area, be achieved."

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