Fed Chief All but Promises a Rate Cut; Stock and Bond Prices Rise in Response

Federal Reserve Chairman Alan Greenspan made clear Tuesday that he’s betting on investors to show the way to an economic recovery.

And to keep stock and bond buyers on the bullish path, Greenspan offered the potential for another Fed interest rate cut.

The central bank chief’s latest comments on the economy and markets, made in a speech to a bankers’ conference in Berlin, appeared to have the desired effect: Yields on some Treasury securities fell to generational lows, and major stock indexes rose to their highest levels in at least six months.

The Fed, which surprised Wall Street four weeks ago by warning of the possibility that the weak economy could fall into a deflationary cycle, is showing that it is entirely focused on the need to stoke growth, analysts said. Any concern about the longer-term potential for higher inflation -- Greenspan’s No. 1 worry for most of his career -- has evaporated, they said.

Though some veteran investors have questioned whether Fed policy is helping to pump up potentially dangerous bubbles in the stock, bond and housing markets, that is a risk the central bank now seems happy to take.

“The Fed wants to see easy financial conditions and they want to see a booming stock market,” said Ethan Harris, chief U.S. economist at brokerage Lehman Bros. in New York.

A continuing decline in interest rates would make housing more affordable, fuel another wave of money-saving mortgage refinancings among existing homeowners, and allow companies to refinance their debts at cheaper rates, Harris said.

A further rise in stock prices would be expected to bolster the economy by raising confidence among investors and companies, encouraging both to spend.

Greenspan, in a speech delivered via satellite, said the Fed believes that the economy stabilized in May but that a revival “has not yet begun.” However, he said that the action in financial markets since mid-March -- the surge in stock prices and the decline in yields on higher-risk bonds -- indicates investors believe a rebound is on the horizon.

“What we have is the makings of a turnaround in economic activity which in the past has almost always been signaled by an improvement in financial conditions,” the Fed chairman said.

As for the risk of deflation -- usually defined as an extended weakness in spending that causes a broad-based decline in consumer prices, such as what Japan has been dealing with in recent years -- Greenspan reiterated that the Fed considers it unlikely that such a cycle could begin in the United States.

Even so, he said, the central bank believes it can’t take the chance that its policies could be too restrictive and push the economy toward deflation.

“While we, dealing with inflation, have essentially some element of certainty about what it is we need to do, we are far more unclear on the issue of deflation,” he said. “As a consequence, in one sense we need a much wider firebreak ... because we know so little about it, so we lean over backward to make certain we contain deflationary forces.”

Wall Street interpreted the comments as almost assuring that the central bank’s benchmark short-term interest rate, already at a 41-year low of 1.25%, will be cut again when policymakers meet June 24 and 25.

Peter Hooper, economist at Deutsche Bank Securities in New York, expects the Fed to cut its rate to 1%. Harris expects a half-point cut, to 0.75%.

More important, some say, is that Greenspan continues to signal that the Fed won’t be raising interest rates soon, even if the economy begins to turn.

The message is “they will be on hold for a protracted period of time,” said Tad Rivelle, a principal at Metropolitan West Asset Management in Los Angeles.

Bond investors anticipate at least a quarter-point cut at the meeting later this month, Harris said. That is evident from the yield on the two-year Treasury note, which slid to a generational low of 1.2% on Tuesday from 1.3% Monday. Normally, the two-year T-note yield would be above the Fed’s rate, which is the overnight loan rate among banks.

Longer-term Treasury yields also declined. The 10-year T-note yield, a benchmark for mortgage rates, sank to 3.33% from 3.41% on Monday, and is just above the generational low of 3.32% reached May 22.

On Wall Street stocks rallied modestly, but enough to send key indexes to their highest levels since at least November.

The Dow Jones industrial average gained 25.14 points, or 0.3%, to 8,922.95, its highest close since Nov. 27. The Dow rose even though IBM sank $3.51 to $83.82 after saying Monday that the Securities and Exchange Commission is investigating its revenue accounting.

The Standard & Poor’s 500 index rose 4.56 points, or 0.5%, to 971.56, its best close since July 8.

The Nasdaq composite index added 12.81 points, or 0.8%, to 1,603.56, its first finish above 1,600 since May 2002.

Rising stocks outnumbered losers by 18 to 15 on the New York Stock Exchange and by 16 to 15 on Nasdaq. But trading volume retreated from recent peaks, and some analysts said the market could be tiring after its powerful recent advance.

What the Fed has achieved this year by keeping interest rates low, promising additional cuts if needed to guarantee an economic recovery and by stressing that inflation is no longer a problem, is to spur rallies in many disparate markets -- high-quality bonds, junk bonds, stocks, housing, even gold.

In a sense, the Fed has offered something for everyone, except for short-term savers.

“It’s not very often you get rallies in everything,” Harris said.

A major risk is that interest rates could snap back if the economy indeed rebounds. That could slam investors who are locking in yields at current levels.

But for now, the Fed isn’t interested in stopping investors from buying bonds and pushing yields even lower, analysts said.

Market Roundup, C6-7

Reuters contributed to this report.