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Investors to the Fed: More!

No good deed goes unpunished. That may be what Federal Reserve policymakers were thinking after they saw the market's reaction to their quarter-point interest rate cut on Aug. 21.

As expected, the Fed dropped the federal funds rate -- what banks charge each other for overnight loans -- to 3.5% from 3.75%, and it sliced the discount rate -- what the Fed charges banks for overnight loans -- to 3% from 3.25%. It was the Fed's seventh fed funds rate cut so far this year. Rates have been chopped three percentage points since Jan. 3 and now stand at the lowest level in seven years. It has been the most aggressive easing campaign in 20 years, yet investors still aren't satisfied.

The Dow Jones industrial average ended the day nearly 150 points lower, and the tech-laden Nasdaq dropped 50 points. Financial futures contracts, a key gauge of market psychology, ended the day with investors signaling that they believe the Fed needs to lower at least another quarter point, if not a half point, before yearend.

DIFFICULT SCENARIO. All fine and good. Clearly, investors have ample reason to remain worried about the economic outlook, considering that growth barely budged last quarter and might not be doing much better this quarter. But the dollar sold off on Aug. 21 after the Fed's move. The greenback hit a five-month low against the euro and is now 10% below its 2001 high. Bill Gross, the manager of PIMCO, the world's largest bond fund, warned that the weakening dollar could cause a foreign stampede out of U.S. assets, adding to the economy's and market's woes.

Such a scenario would make life incredibly difficult for Fed Chairman Alan Greenspan and his central bank colleagues. The economy has been slower than usual to react to monetary stimulus this go-round, and the markets and Corporate America are clamoring for more rate cuts to goose it. Yet if the dollar continues to weaken, the Fed's hands could be tied when it comes to further easing. Or worse yet, the Fed could be forced to reverse course and raise rates in an effort to bolster the buck.

The Fed signaled that it remains ready to keep cutting. The spartan four-part policy statement announcing the Aug. 21 move was nearly identical to that of June 27, with some subtle differences. The policy bias that "risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future" remained intact. The Fed also repeated that easing wage and price pressures should keep inflation contained.

PETULANT LOT. The Federal Open Market Committee, the Fed's policymaking arm, stood by stock phrases that "business profits and capital spending continue to weaken and growth abroad is slowing, weighing on the U.S. economy." In an interesting positive departure, the committee noted that "household demand has been sustained" as opposed to "weak expansion of consumption" last time around.

Reading between the lines, it would be a stretch to call this an "all clear" before the Fed reverts to a neutral bias -- where it leans neither toward easing nor tightening. The Fed's productivity mantra was also tweaked slightly, revealing favorable long-term prospects for productivity growth and the economy, rather than implying that productivity gains would continue without interruption, as the Fed said in its June 27 statement. Perhaps the recent downward revisions to productivity data have tempered policymakers' enthusiasm.

It appears that the markets were disappointed that the end of the cycle was not signaled and that the Fed needs to do more to get the economy back on track. Investors can be a petulant lot, especially in the frenetic hours following a Fed move, even when the size of the cut or the thrust of the Fed's statement held no surprises. Market action in the coming days and weeks -- as traders digest this move and vacationers return to their trading posts -- will provider a clearer picture of where investors think the economy is headed.

And while Greenspan has long made clear that his Fed doesn't bow to the market's demands, he may have some of the trickiest terrain yet ahead of him as he attempts to steer the economy clear of recession. The next Fed policymaking meeting is Oct. 2, and he and investors must be hoping that before then, more vital signs of a recovery appear. By Michael Wallace, senior economist, Standard & Poor's Global Markets

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