Stocks closed moderately higher after investors shrugged off the Fed's continuing worries about inflation to buy beaten-down financial shares.
"The Fed announcement, I think quite honestly, was annoying," said Jack Ablin, chief investment officer at Harris Private Bank. "I'm glad the market reacted positively to it. The fact that they are on a hawkish bias to me is wrong. I think they ought to be back at neutral."
The Fed kept the fed funds rate at 5.25%, as expected. Although the FOMC said core inflation readings have improved moderately in recent months, Fed officials said the predominant risk to the economy was that inflation won't fall as expected.
"Right now Bernanke seems to be an inflation hawk and until we have a major blowout, like a big money center bank going out of business, he's not going to act," Eric Roseman, investment director for Sovereign Society, told CNBC.com. "The market is mopping up its own excesses without the Fed."
Trading was volatile, with the Dow at times posting a triple-digit swing in either direction.
"The market expected a little more from the Fed in terms of heading toward an ease," said Bob Doll, global CIO at BlackRock. "A 5.25% fed funds rate is more punitive today than it was just a few weeks ago and that's part of why the volatility is here."
The market rebounded after buyers went back into financial stocks. Brokers, which fell after the Fed statement, rose again, helping to turn the market around. The energy sector, which had been beaten down by lower oil, rose sharply, gaining more than 2%. Technology, which had been the worst performing sector much of the session, briefly rose higher, then turned negative in the final minutes of the session.
"I think the broader market is lost and it's looking for direction," said Roseman. "We are not going to know how significant subprime will be until later in Q3 or maybe even Q4."
Treasury prices fell, sending yields higher.
Second-quarter productivity rose 1.8%. Nonfarm productivity was expected to have risen by 2%, compared to the previous quarter. Unit labor costs also rose 2.1% in the second-quarter. Even though that was lower than the previous quarter, it was a bit higher than some economists were looking for and some investors were concerned it would not alter the Fed's focus on inflation.
Quarterly earnings continue to come in.
Tyco International said it fell to a fiscal third-quarter loss due to hefty charges primarily related to a legal settlement, but adjusted results still managed to beat Wall Street expectations. Excluding $3.3 billion related to a legal settlement, charges and other items, Tyco posted income of 55 cents a share. Analysts surveyed by Thomson Financial were expecting earnings of 48 cents a share.
Harrah's Entertainment , which is being taken private, said its second-quarter profit surged 85% on strong results in Las Vegas and Atlantic City. However, adjusted results from continuing operations missed estimates.
Also on the earnings front, Chrysler is expected to make a profit within three years, according to John Snow, the Chairman of the automaker's new owner, Cerberus Capital Management.
Meanwhile Germany's DaimlerChrysler is officially dropping the Chrysler from its name this week and will change its ticker symbol to DAI from DCX on Thursday.
In corporate news, technology isin focus after Microsoft was cleared of infringing on patents held by France's Alcatel-Lucent and speculation is mounting that Apple could unveil an updated version of the iMac computer, AP reported citing one analyst.
New York light sweet crude futures rose to trade above $72 a barrel, following sharp losses from Monday on concerns about the U.S. economy.
European Stocks Close Sharply Higher
The major European indexes finished firmly higher across the board Tuesday, due to solid corporate earnings and Monday's spike in the Dow in the U.S. market.
The London FTSE-100, Paris CAC-40 and Frankfurt DAX all finished solidly higher.
On the earnings front in Europe, insurer Standard Life posted a 31% rise in first-half sales. Shares of the British firm rose.
German drug-maker Bayer reported a 30% jump in quarterly operating profit, after having raised its profit guidance in June.
Britain's biggest brewer, Scottish & Newcastle, missed first-half profit expectations and said meeting targets for the full year would be very challenging. Shares of the drinks maker fell.
Andreinsurer Swiss Re posted a 45% rise in second-quarter profit and said it expected strong full-year results.
In other corporate news, Xstrata announced a $1 billion offer for South Africa'sEland Platinum Holdings. The mining firm also met forecasts with a 47% rise in first-half net profit. Shares of Xstrata were lower.
Asian Stocks Mixed
Tokyo's Nikkei 225 Average ended flat as computer software firm Trend Micro surged on a better forecast, but a drop in crude oil prices hit trading house Mitsubishi Corp. and other energy-related stocks. Trade was mixed as investors focused on individual stocks with solid profit outlooks or positive news flow. Toshiba extended gains for a third day on rising NAND flash memory prices, while its rival Fujitsu fell on its plan to issue convertible bonds.
South Korean shares managed to eke out a slight gain as financials such as Kookmin Bank tracked stronger U.S. stocks amid easing worries about credit markets. But oil refiner SK Energy was hit by a drop in crude prices. Stubborn worries about the U.S. economy dragged the benchmark KOSPI back towards breakeven by the close.
Australia's S&P/ASX 200 Index finished 1% higher as the rebound on Wall Street prompted investors to snap up shares in financial firms including Macquarie Bank and banks that had been sold down in the previous session.
Steel stocks boosted by expectations of strong interim earnings, led China's Shanghai Composite Index up to a fresh record high even though most stocks fell on profit-taking.
Hong Kong stocks retreated from early strong gains in the morning session, as Wall Street's good performance was offset by persistent fears over the fallout from the U.S. subprime mortgage woes. Financials stocks, which were hammered on Monday, staged a strong rebounded with HSBC and Bank of China both climbing.
Singapore's Straits Times Index also lost early advances, but banks such as United Overseas Bank were recovering some of yesterday's sharp losses.