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Easing Up on Rate Cuts

By Rick MacDonald The Fed has dropped the Fed funds target rate 250 basis points so far this year, and the market is confident that more easing lies ahead. The big question is how much? Both the market, as measured by the Fed funds futures contract, as well as S&P's weekly survey of forecasters, suggest it is a toss-up as to whether Greenspan & Co. will opt for a cut of 25 or 50 basis points at the June 26-27 meeting of the Federal Open Market Committee, the Fed's policy-setting arm.

While we at S&P MMS give a slight edge towards a more gradual 25 basis point easing (with policymakers maintaining an easing bias) it admittedly will be a close and contentious call for FOMC members.

NO IMPROVEMENT. Favoring a more aggressive move is the fact that the three biggest concerns expressed by the FOMC in its May meeting press release have shown no sign of improvement. First, not only have data on capital spending remained abysmal, but the likelihood of any impending rebound continues to get pushed further out on the horizon. Second, the stock market, as measured by the Wilshire 5000, is currently sitting below the level that was in place during the May meeting. Thus, the Fed is likely to still view reductions in equity wealth as a restraint on consumption going forward.

Last, but certainly not least, is the Fed's expressed concern over the risk of slower growth abroad. Recent data from Japan indicate that recessionary conditions are taking hold in the region, while Europe is revealing an unfortunate mix of deteriorating growth with rising inflation that has some forecasters throwing around the "R-word" there, too. And given that the Fed's own anecdotally-based Beige Book revealed one of the more downbeat reports in recent memory, the Fed certainly has the proverbial "smoking gun" to go for another big move.

But a strong case can be made for this Fed being willing to move on forward-looking hunches, leaving them less reliant on available data. Thus, we could see the Fed come to the conclusion that this is the darkest part of the night for the economy given the fiscal and monetary stimulus that sit in the pipeline. As such, a downshift to a more gradual policy course is warranted. One possible reason: The tax rebate was approved after the May meeting. Given the potentially huge impact it could have on consumption, this could get a mention in the press release.

RATE ROWS? Also, the easing bandwagon is losing some steam at the Fed. Recent Fedspeak -- especially from one admitted inflation hawk, Governor Meyer -- suggests that for the first time this year, upside risks could be coming back on the radar screen. In addition, the May meeting press release revealed some "hidden" dissension as well, as only five Federal Reserve Banks requested a 50 basis point decrease -- the smallest number this year.

The minutes from the last Federal Reserve Board meeting (not to be confused with the FOMC minutes) revealed that six banks sought only a 25 basis point move, while one voted to maintain rates. Thus, it's possible that the May decision was already much more contentious than appeared on the surface.

Overall, while it is widely acknowledged that Greenspan seeks uniformity in the publicly-released decision, the hawks may be near the breaking point. Thus, a 25 basis point move may be the only move that all are willing to accept. The press release that follows should help provide a qualitative context for the quantitative decision, as well as set the tone for what the Fed, and thus the markets, will be focusing on in the weeks ahead. MacDonald is a Senior Economist for Standard & Poor's Global Markets

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