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Amid Uncertainty, the Fed Buys Some Time

By Michael Wallace The Federal Reserve Bank delivered on the promise priced into the Treasury futures markets by slashing both the federal funds and discount-rate targets a half percentage point on Oct. 2, to 2.5% and 2% respectively -- the lowest they have been since 1962. Yet the tone of this latest round of easing was somewhat different than that of Sept. 17, when the Fed administered emergency financial aid with the reopening of the stock markets on Sept. 17. Clearly, these are unusual times. And it seems possible that a natural end zone for the funds target in this "uncertain" climate would be a measurably negative real interest rate, which is already about a half-point below the 2.7% level of retail inflation in August.

The Fed statement accompanying the Oct. 2 rate cuts warned that "terrorist attacks have significantly heightened uncertainty in an economy that was already weak. Business and household spending as a consequence are being further damped." On Sept. 17, the Fed was fairly explicit about the "unusually large volumes of liquidity" it planned to supply until normalcy returned following the financial dislocations. This time, there was no reference to such injections or the concept of the funds-rate target operating as more of a ceiling than a floor. Along with the anecdotal evidence of the Fed's daily operations, this latest statement suggests that the phase of elevated systemic emergency liqueficaction might be coming to an end.

LITTLE TO SAY. The Fed's current target effectively lines up official rates with the actual impact of its previous market operations. And it's still banking on favorable long-term productivity and economic growth trends following these recent emergency steps. Meanwhile, it steadfastly views the risks as "weighted mainly toward conditions that may generate economic weakness in the foreseeable future." There was not much else to read into the Fed's parsimonious four-paragraph statement.

Stocks doubled back but closed higher after the move, while the bond market just churned after setting contract highs. The dollar finished a jumpy session mostly mixed. The yield curve first flattened amid recent sizable profit-taking on five-year Treasury notes, then steepened back out.

Fed funds and Euro$ futures surged in the wake of the Fed's announcement, pricing in at least one more quarter-point ease by the end of the year. On Fed funds, the November contract traded at an implied rate of 2.33%, while the December contract implied a rate of 2.21%, with 2002 contracts slipping to the 2.14% area. March-02 Euro$ futures surged to a fresh contract high of 97.59, implying a rate of 2.41%.

DISTORTED DATA. S&P MMS sees room for another quarter-point cut at the next meeting on Nov. 6, which would bring the inflation-adjusted or real funds rate down to negative 0.45%. Much depends upon upcoming data that will be available prior to that meeting, including October Payrolls, which is set to be released on Nov. 2. But the bulk of the data between now and then will be distorted by the shocks of Sept. 11, without much clarity until the end of the year -- a foreseeable horizon for the Fed. Even following the significant cumulative four percentage points of easing so far this year, consumer and business sentiment remains fragile. Geopolitical events could yet sway the Fed's policy hand as the lender of last resort.

By the end of 2001, the visibility for economic data should improve. Following its own advice to Congress, a pause on the part of the Fed to reflect on recent events and policy remedies would be wise. President Bush and the fiscal gatekeepers have picked up on Federal Reserve Chairman Alan Greenspan's cautious refrain, perhaps encouraged that he will do his part to buy them time. Wallace is chief market strategist for Standard & Poor's Global Markets

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