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The Fed Bows Out Of The Picture

Yesterday's announcement from the Federal Reserve on interest rates was remarkable in that it contained nothing positive for investors.

The Fed cut the Fed funds and discount rates by only 25 basis points each, ending a string of five 50-basis point rate cuts. At the same time, the accompanying statement contained none of the positives, such as strong consumer confidence and home sales, included in other recent statements, making it hard to argue that the Fed took yesterday's action because it thinks the economy is improving. And the Fed gave no hint this time that it is willing to cut rates between meetings.

"The patterns evident in recent months - declining profitability and business capital spending, weak expansion of consumption, and slowing growth abroad - continue to weigh on the economy," the FOMC said. "The associated easing of pressures on labor and product markets are expected to keep inflation contained."

That statement - a weak economy coupled with low inflation pressures - seems to argue for another 50 basis point rate cut. So why didn't the Fed deliver?

One answer is that the Fed's inflation hawks, who have become more vocal in recent weeks, are beginning to assert themselves. Some FOMC members have expressed concern that the Fed's aggressive rate-cutting could spark inflation. Yesterday's 25-basis point discount reduction was requested by only seven of the 12 regional banks, which have been concerned about the 50-basis point actions pushed by Chairman Alan Greenspan.

Another answer is that the Fed is simply running out of room to cut rates. The 3.75% Fed funds rate and 3.25% discount rate aren't too far from the 3% level reached on both rates in 1992-1993. The Fed wants to hold back something in case the economy remains persistently weak or worsens, and to go lower than 3% would take short-term interest rates below the rate of inflation and to a level not seen in 40 years.

The third reason is that the Fed probably wants to give the 275-basis points in rate cuts since the start of the year time to work. As we pointed out two days ago, businesses have a tendency to put off new investments during Fed rate-cutting cycles in the hope that rates will get even lower. By signaling an end to the most aggressive part of the easing cycle, businesses could be forced to implement delayed capital spending plans. And right now is about when the first rate cuts should be starting to be felt.

But whatever the reason - and all of the above likely played into the decision - the result is that the Fed has now removed itself from the picture. Investors will now be watching the economy and corporate earnings for signs that the rate cuts are beginning to work. Two straight declines in weekly jobless claims and stronger than expected durable orders and consumer confidence are a start, but a rebound in economic readings in February turned out to be a blip in a bigger downtrend. It will take more than a week of data to signal that the bottom for the economy is in. And technology and manufacturing remain mired in recession.

In the short run, the Fed's admission that things are bad and that it has done about all it can do to help might spark one of those perverse market rallies that tend to occur after all the bad news is out. But for any gains to be sustained, the economy and corporate earnings will have to begin to show improvement.



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