Capital infusion to the rescue...

There was talk earlier in the year that in the event of a stock market meltdown, the Fed would not hesitate to intervene by cutting rates aggressively just like it had done several times under the helm of Greenspan. It was also said that private equity firms had piled up a large amount of cash and were just waiting on the sidelines for the opportune moment to start buying again.
Things turned out differently, however, with a Fed under Bernanke hesitant to cut rates more energetically due to concern with regards to inflation. Private equity also stalled somewhat as the ensuing credit crunch took its toll on their ability to borrow cheaply. For a moment it seemed that there would be no way of averting a full blown sell off as the notion of an embedded put option seemed more of a fallacy than anything else. The situation changed, however, as large financial institutions began to disclose their large subprime related write offs. Suddenly, we saw cash infusion offers coming from Asia and the Middle East. Morgan Stanley, Citi, UBS and Merrill all received offers of cash in exchange for a stake. It seems that the embedded put option is very much alive.
This pattern also highlights an exchange that can only increase in importance in time. Emerging markets with their young population and large cash reserves are hungry for investment opportunities in contrast to developed nations with their aging populations and large deficits and an increasing willingness to sell their bonds and stocks to finance their retirement.

Behind the curve?

There is growing concern amongst market pundits that the Fed under Bernanke's helm is not doing enough to counter the economic troubles ahead. Since the Fed first took action after the subprime crisis earlier in the year, a very distinct style and one in sharp contrast to the former chariman's has emerged. Academic and consensus based are two keywords that aptly describe Bernanke's fine tuning style and although it may be appropriate in times of relative calm, it does not seem suitable in an environment of turmoil. It is also in sharp contrast to the quick and dirty or more authoritarian style of Greenspan who did not hesitate to take radical action in times of duress. He has, for example, received credit for averting a deeper recession from the internet bubble.
Nevertheless, navigating in the current crisis is proving to be extremely challenging (even Greenspan recently remarked that the current environment is probably the most difficult he has ever observed) not only because of the two forces (inflation and growth) moving in opposite directions but also because unlike previous downturns, the origins of the current one is the credit market and the extent of the damage is still difficult to asses with any degree of accuracy due to the opaque nature of the instruments behind the subprime boom of earlier years. Most recent inflation figures are indicating the beginnings of a surge which in a way restricts the Fed's room for maneuver on the side of easing.
What is clear is that the market have so far been disappointed with the way in which the Fed is handling the crisis. The most recent 25 basis point cut in the discount window was perceived as just a symbolic move and nothing else. Yesterday's announcement of a proposal of introducing more stringent rules on mortgage borrowing is also seen as not enough to curb the crisis. Time is of the essence and every mistake now will incur a large penalty later.

Too little, too late?

That is at least what the markets seem to be signalling after the FOMC decision to cut the key target rate and the discount rate by 25 basis points each and announce a change in focus from the more balanced growth and inflation worries to growth worries only.
The Fed's behavior since it first started taking action in August suggest a reluctance to ally market fears that the risk of an economic slowdown is greater than that of a surge in inflation. The Fed seems more concerned that further cuts will fuel a rise in inflation. From their remarks, they also seem to be confident that fine tuning on various fronts (key rate, discount window, extension of loan periods etc) in coming weeks and months will suffice to calm credit markets thereby averting a full blown recession. Markets clearly disagree, some economists going as far as suggesting that a recession may already be under way.
Nevertheless, there seems to have been a shift in strategy within the Fed as nine out of the ten voting members voted in favor of the 25 basis point cut (the dissenting voice was in favor of a 50 basis point cut) in contrast with the prior meeting in October in which the only dissenting voice was in favor of keeping rates steady.
As the economy continues to suffer in an environment in which borrowing is becoming increasingly difficult and costly, the impact that is already being felt amongst businesses will eventually trickle down to consumers (that are already feeling the strain of the housing recession and rising commodity prices). In other words time is of essence if the Fed has any chance of averting a more severe downturn in growth.

Markets in a state of euphoria...

It has been a week of revived optimism as upbeat economic releases (better than expected productivity figures compounded by lower than expected unit labor costs and a stronger than expected rise in employment) congregated with a government plan to put a stop to the subprime hemorrhage and the near certainty of another quarter point cut next week.
These events sent global stock markets higher as the risk of a full blown recession in the U.S. somewhat receded. Oil prices dropped as tensions between the U.S. and Iran subsided and treasuries receded as the probability of a larger Fed rate cut diminished and more money poured back into stocks.
The buzz is unlikely to last very long, however, as most of the economic indicators provide a snapshot of the past making an assessment of the current state of the economy nothing more than a wild guessing game. As far as indicators go, the 3 month Libor to 3 month t-bill spread still remains relatively high, suggesting that there still remains a significant amount of distrust and uncertainty plaguing the credit markets. The subprime mess is far from being resolved and another cut in interest rates will also raise the risk of inflation in the future (as the current shape of the treasury yield curve would suggest).