Fed Seen Nearing End to Rate Cutting

After six months of effort to keep the economy out of recession, the Federal Reserve this week will have to ponder whether it has done enough.

Central bank policymakers meet Tuesday, and expectations still are high that they will cut their benchmark short-term interest rate, now 4.5%, for the fifth time this year.

But the size of the cut was the subject of some debate on Wall Street by late last week. A half-percentage-point cut had seemed a slam dunk--until surprisingly strong economic data arrived Thursday and Friday.

Though the majority of economists still expect a half-point move Tuesday, many also believe the Fed will signal that it is probably nearing the end of its credit-easing campaign, which has already reduced short-term rates two full percentage points to a six-year low.

From financial markets’ point of view, the language the Fed uses in its statement this week may be more important than the cut.

Since Chairman Alan Greenspan and his Fed peers began pushing short-term rates lower on Jan. 3, they have emphasized in official statements that the risk of recession outweighed other concerns in the economy--such as the risk of reaccelerating inflation.

But some experts say the time is ripe for the Fed to indicate that it remembers its role as the economy’s inflation watchdog.

“If the Fed does ease by 50 basis points [a half-point], the statement should signal a shift to a less-aggressive stance” on further easings, said Martin Mauro, manager of financial economics at Merrill Lynch & Co., in a report to clients Friday.

Otherwise, the bond market could make trouble for the Fed, Mauro and others say.

While the Fed has cut short-term rates twice since March 20, long-term Treasury bond yields have been rising steadily since then. That reflects bond investors’ growing belief that the economy is poised for recovery later this year, which could put upward pressure on all rates--and on inflation.

If the Fed appears unconcerned about the risk that continued credit easings could set the stage for a sharp economic rebound, and higher inflation, in 2002, investors could flee long-term bonds, driving yields substantially higher, some say. That message grew louder on Friday, when bond yields rocketed in the wake of two reports pointing to underlying strength in the economy.

The government said retail sales in April were much better than expected, while the University of Michigan’s monthly consumer survey showed a rebound in confidence in May, after a long slide.

Those reports, and some others in recent weeks, have all but erased any idea that the economy is in a free fall, though most analysts believe that the overall picture remains weak.

On Friday, many bond investors seemed insistent that the danger of recession has passed, and that the Fed ought to be prepared to declare victory.

The yield on the 10-year Treasury note soared from 5.29% Thursday to 5.45% Friday, the highest since early December. That yield has risen nearly 0.70-point since late March.

The Fed controls short-term interest rates, but long-term rates are set by the marketplace. And if bond yields continue to rise--driving up the cost of long-term credit for consumers (especially for home mortgages), companies and local governments--the net effect could be to tip the economy back toward recession, said James Bianco, a bond market expert at Bianco Research in Barrington, Ill.

He said he worries that Greenspan is too intent on bailing out the stock market, and particularly technology companies, with lower short-term rates, while sacrificing the rest of the economy.

“Outside tech and telecom, the economy is hanging in there,” Bianco said. “But what will hurt the rest of the economy? Higher long-term rates.”

Experts note that growth of the nation’s money supply has exploded this year, a direct effect of the Fed’s credit-easing campaign.

“The rapid expansion in money supply is likely to rekindle economic growth” later this year and in 2002, said Sung Won Sohn, chief economist at Wells Fargo & Co. But “the surge in money supply also could add to inflation in the future” by spurring demand, he said. Bond investors fear inflation because it erodes the value of bonds’ fixed returns.

Still, many analysts believe that the economy’s mounting job losses will force the Fed to err on the side of guarding against recession, at least for one more meeting. Though the language the Fed will use Tuesday may be key, 24 of 25 major Treasury bond dealers polled by Reuters on Friday still see a half-point rate cut as assured.

The Fed may fear the bond market, but it also fears shocking the stock market, economists note. Stocks have rallied broadly from two-year lows in early April, and fell only modestly on Friday even as bond yields surged. Analysts say that reflects equity investors’ trust that at least one more half-point rate cut is certain.

“If the central bank does not deliver the expected cut, the stock market could sell off sharply, contributing to further economic slowdown,” Sohn said.