What Markets Want From the Fed Still a Mystery

The Federal Reserve Board can play either Santa or Scrooge with interest rates on Tuesday. But just which of those options financial markets would truly prefer remains a puzzlement.

As Fed Chairman Alan Greenspan gathers his policy-making committee for its final meeting of 1995, bond and stock markets appear to be crying out for a cut in short-term interest rates.

The central bank has been holding its benchmark short-term rate, the overnight federal funds rate, at 5.75% since July 6. But in the marketplace investors have already bid yields on short-term Treasury bills down to the 5.35% range--an apparent bet that the Fed will shave at least a half-point from the federal funds rate.

In the stock market there is little argument that much of the rally of the last seven weeks has been built on the assumption of easier money ahead. The Standard & Poor’s 500-stock index, which hit an all-time high of 621.69 last Wednesday, finished the week off slightly at 616.34, but still is up 6% since Nov. 1 and a stunning 34% year-to-date.

Yet many economists don’t believe that a Fed cut is a slam dunk for Tuesday. And by late last week there were plenty of analysts forecasting that the best thing for stock and bond markets, in fact, would be for the Fed to do nothing--a twisted logic, but remember that we’re dealing with Wall Street here, a place where people can talk themselves into just about anything.

The case for a rate cut, of course, has been based on the perception that the U.S. economy is slowing dramatically again and needs cheaper money to revive or just to avoid falling into recession.

Proponents of lower rates see worrisome economic signs wherever they look: Christmas retail sales are disappointing at best, many manufacturing businesses are scaling back production and inventories of unsold goods are piling up at factory and retail levels.

What’s more, the economic outlook in recession-wracked Japan remains iffy despite record low interest rates. And Germany’s Bundesbank, the Fed’s Teutonic equivalent, last Thursday cut its benchmark short-term interest rate from 3.5% to 3%, a 7 1/2-year low and a move that some analysts viewed as a sort of elbow to the Fed’s ribs to get with the program.

“As you pan around the world there are more signs of new economic weakness than new strength,” contends Paul Kasriel, chief domestic economist at Northern Trust Co. in Chicago.

“The Fed has its foot on the economy’s neck,” says Scott Grannis, economist at Western Asset Management in Pasadena. “If they don’t let up we could have a recession by summer.” He believes the central bank should cut short-term rates by the half-point the markets are indicating.

But that sentiment isn’t universal. Last July, after the U.S. economy grew at a paltry annualized real rate of 1.3% in the second quarter, there was much more conviction on Wall Street that the Fed needed to ease credit. And Greenspan & Co. quickly concurred, shaving the federal funds rate from 6% to 5.75% on July 6, the first reduction in three years.

But now, even many supporters of lower rates admit that the evidence of pronounced U.S. economic weakness isn’t all that overwhelming. For example, inflation at the wholesale level jumped 0.5% in November, something untypical of a slumping economy (although one could argue that, like most statistics, the wholesale inflation report was skewed by seasonal factors).

Robert Brusca, economist at Nikko International in New York, notes that the economy has still been creating net new jobs in recent months, albeit at a slower pace, as service businesses have continued to expand. And the durable-goods area of the manufacturing sector has lost a mere 1,000 jobs, net, over the last 12 months, Brusca says--despite the sharp deceleration in U.S. growth overall.

That doesn’t sound like an economy that’s falling off a cliff, Brusca says. The national unemployment rate, he notes, is just 5.6%, a level that to some experts almost constitutes full employment, meaning the most productive use of the labor force without inflationary pressures.

“With unemployment at 5.6%, what are you going to stimulate [in the economy] with lower interest rates?” Brusca asks rhetorically.

In public comments recently, some Fed governors appear to have been making the same point. Greenspan himself has said that he is concerned about higher wage inflation in 1996 stemming from a too-tight labor force.

Fed Gov. Edward Kelley last week declared that the economy will have a “slow to medium growth path over the coming year,” a statement that seemed to suggest the Fed ought to be happy with the way things are.

“I think they’ve been trying to deflate some of the optimism” about lower rates, said David Jones, economist at bond dealer Aubrey G. Lanston & Co. in New York. “There are some in the Fed who feel we now have ideal conditions” in the economy.

The Fed may also have concerns about accommodating what could viewed as a large speculative bubble in stock and bond markets this year, pumped up by optimism that interest rates can only go down from here. That is also how some people were feeling in late-1993--just before the economy zoomed, forcing the Fed to begin tightening credit in 1994 and thus exploding the huge bond market bubble of the time.

But if Fed governors are going to focus on sending the “right” message in Tuesday’s rate decision, they run the risk of following Alice into Wonderland: Whatever the decision, it may be interpreted in financial markets quite differently than what the Fed might intend. Logic and proportion in this case can easily be turned upside down.

Take, for example, the backdrop of the budget battle in Washington. The widespread assumption on Wall Street and in Washington has been that the Fed would ease rates Tuesday if Congress and President Clinton had succeeded in hammering out a long-term balanced budget plan.

A Fed cut could then be justified in part because an expected slowdown in government spending could pose a bigger threat to the decelerating economy. Looser credit would be needed to offset those effects.

But no budget agreement is yet in sight. So it would be wrong for the Fed to “reward” Congress and the White House with lower interest rates, right?

Maybe not. Aubrey Lanston’s Jones argues that the lack of a budget deal now makes it more likely the Fed will clip a quarter-point off the federal funds rate Tuesday. That would demonstrate that the central bank focuses only on the economy and isn’t playing political games, Jones says.

“I do not think the Fed wants to link its rate moves to the budget process,” he says. “They want to retain their image of independence.”

What about financial markets’ potential reaction to the rate decision? Knowing how low bond yields have already been pushed, and how high stock prices are, many investors might assume that if the Fed decides to pass on Tuesday markets will turn violent.

Not so, contends Jack Kallis, who manages $1 billion in bonds at the MetLife/State Street mutual funds in Boston. “That would probably make me more bullish” on bonds, he says, “because if they don’t cut then there’s more of a chance the economy will slow further,” which should put more downward pressure on long-term bond yields and inflation.

Notably, the bellwether 30-year Treasury bond yield remained near two-year lows last week despite increasingly cautious comments from Fed officials about the chances for a rate cut. The bond yield closed at 6.09% on Friday, up only marginally from the two-year low of 6.02% set on Dec. 4.

And if the bond market rallies further, a significant chunk of the stock market would probably go along for the ride. At least, that has been the story all year.

Maybe it’s wishful holiday thinking encouraged by too much egg nog, but many Wall Streeters believe that the markets’ basic bullish tone won’t change for long almost regardless of what the Fed does Tuesday.

A quarter-point rate cut, for instance, would suggest a cautious Fed, but one still moving in the direction investors want: toward easier credit.

No rate cut would just whet peoples’ appetite for what might happen in late January, when the Fed meets again. “I think the feeling is that the Fed is sure to cut sometime in the next two months,” if not on Tuesday, says Alfred Kugel, investment strategist at Stein Roe & Farnham in Chicago.

A half-point cut, meanwhile, might be the move most likely to cause a sudden wave of profit-taking in stocks and bonds, because some investors might fear there isn’t enough of the same to come.

But if bond yields rise sharply and stocks take a hit, history is on the side of those who would call it a great opportunity to buy. A moderately growing economy with a friendly Fed still is the best recipe for a continuing bull market in stocks and bonds.