The Fed cut the discount rate by 50 basis points to 5.75%, the first time since the early 1990s that the discount rate has been changed without a change in the Federal funds target (now at 5.25%). In addition, the Fed extended the term on discount window loans from overnight to up to 30 days, with the loan renewable by the borrower. Finally, the Fed?s statement effectively dropped FOMC?s tightening bias, acknowledging that the downside risks to growth had increased ?appreciably? ? setting the scene for a cut in the funds target, if that is deemed necessary.

A few thoughts on this:

First, the Fed?s actions come after the problems in credit markets entered a third, and far more threatening, phase. The first phase, which started early this year, was the meltdown in the secondary market for securities linked to sub-prime mortgages. The second phase, which started a month ago, was the spread of distress to high-risk corporate-debt instruments. This adjustment still largely involved falls in high-risk securities and the closing down of narrow financing flows ? which could still be seen as an appropriate re-pricing of risk. But a third phase, starting the week before last, saw serious disruption to the supply of short-term corporate credit. This was a critical change.

The seizing up of short-end credit markets, most notably the markets for asset-backed commercial paper and nonagency mortgage-backed securities, smacked of a genuine credit crunch, in my view. While the closing down of long-term credit risks the financial equivalent of starving to death, the shutdown of short-term funding risks financial cardiac arrest. If borrowers cannot roll over short-term debt facilities, then we could quickly see corporate failures ? with all the knock-on effects to economic activity that that implies.

Second, markets and policy makers implicitly saw this third phase of credit distress as a much more substantial threat to growth than what had gone before. Whereas initially financial-related stocks had seen the severest contagion from credit distress, through last week investors started to sell aggressively growth-related assets: non-financial equities in developed markets, emerging market equities, and commodities, with a knock-on to the high-yield commodity currencies.

Viewed in this light, the Fed?s actions should not be seen as an attempt to bail out poor investments ? this is no Bernanke put ? but a defensible response to serious financial disruption and an important change in the balance of risks in the economic outlook. Having said that, to the extent that short-term credit flows resume, then the Fed may well err on giving markets as little as is deemed safe in terms of Fed funds rate cuts over the next month. Put another way, the markets may be wrong in expecting a funds rate below 4.75% by November.

Third, while we have seen major disruption in credit markets and they are likely to remain tender for some time ? see Greg Peters? Lifting of the Fog, August 17 ? I expect equity markets to respond quickly to the changed circumstances. In other words, I don?t think it will require a return to full health in credit markets to get a decent rally in equities. On that point, it?s worth noting that our European, Asian and Emerging Market equity strategists all turned bullish on their markets last week (having turned cautious prior to the correction starting).

In the very near term, financial stocks may lead the rally (as they did in New York on Friday ? see Exhibit 1). That is where the shorts were, and short-covering would push them higher. We are likewise likely to see a quick reversal in the sell-down in growth-related assets, such as emerging market equities. But I stick by my bigger picture view that financials, particularly in the developed world, are likely to be persistent under-performers over the medium term. If recent events don?t signal a top in their earnings cycle, I?m assuming that the top will be next year.

Finally, a few bigger picture points:

First, the past month has again emphasized that strength of financial linkages between markets. Because of that, I continue to believe that markets will remain coupled even if we see economic decoupling.

Second, the degree of hyper-leverage within the financial and investment community is now an important source of risk, independent of economic risks.

Third, it is noteworthy that these problems arose in what remains a fundamentally healthy global economy. The stresses would likely intensity ? and be far harder to ease ? if growth started to deteriorate.

Fourth, while the immediate market stress may now ease, the underlying problems in the US mortgage market will not. Nor, therefore, will the likely economic damage from those problems. As I?ve noted before, calibrating that economic damage is not a matter of quantifying the investment loss on already-made sub-prime loans. The economic impact will be due to the fact that over the past four years sub-prime borrowers were given around US$1 trillion, which they then used to build new homes, push up the price of established homes, furnish their homes, and buy the other accoutrements of a lifestyle, which they do not have the incomes to sustain. They will not be getting another $1 trillion over the next four years.