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Why the Fed Cut Deeply Again

By Michael Wallace How low can they go? The Federal Open Market Committee, the Federal Reserve's policy-setting arm, dropped the monetary-policy limbo bar another big notch on Nov. 6, chopping half a percentage point from the federal funds rate target, which was reduced to 2.0%, and the discount rate, which dipped to 1.5%. And in its statement announcing the easing, the Fed also indicated a willingness to keep going.

The Fed's move, in line with expectations, marked the 10th rate cut so far in 2001 and put the fed funds rate at its lowest level since September, 1961. The reduction will keep pushing down financing costs for consumers and businesses as the Fed continues its campaign to stimulate an economy that most likely entered recession in the third quarter. The Fed's policy statement was similar to the one issued after the Oct. 2 FOMC meeting in maintaining a bias toward weak economic conditions that could require further cuts.

ROTTEN OVER THERE. However, Greenspan & Co. included a couple of new and important wrinkles: an acknowledgment of economic weakness outside the U.S. and a warning of temporary restraints in productivity advances. In giving a nod to doldrums here and abroad, the Fed seems to be owning up to its de facto role as the world's central bank. Befitting its status as the global lender of last resort, the Fed noted that "heightened uncertainty and concerns about a deterioration in business conditions both here and abroad are damping economic activity."

The statement from the previous FOMC meeting had a more domestic focus, and perhaps European Central Bank and other foreign monetary policymakers who are set to meet on Nov. 8 will take a page from the Fed's playbook, especially with European economic fundamentals on the decline.

As for productivity concerns, the Fed continues to cling to its optimistic mantra: "Long-term prospects for productivity growth and the economy remain favorable and should become evident once the unusual forces restraining demand abate." But it reinforced a new caveat introduced by Fed chief Alan Greenspan in his Oct. 17 testimony before Congress, that "the necessary reallocation of resources to enhance security" in the wake of the September 11 attacks "may restrain advances in productivity for a time." In other words, the peace dividend may be temporarily suspended in a time of war.

HAPPY INVESTORS. With each successive rate cut, the Fed has, in relative percentage terms, proven ever more aggressive. The cut from 6.5% to 6.0% that began the easing cycle back in January was small on the margin, but the move from 2.5% to 2.0% represents a bigger proportional change. With short-term rates moving toward zero, some Fed-watchers had thought the central bank might cut only a quarter-point on Nov. 6 -- sending a signal that the easing campaign continues but leaving itself more room to keep cutting if need be through the end of 2001 and into next year.

The Fed ultimately decided the more aggressive move was required now. Not surprisingly, the likelihood of one more quarter-point cut before Greenspan completes this easing cycle began to be built into the financial futures markets after the Fed's announcement.

Investors were pleased with the Dow Jones industrial average erasing a 50-point deficit at the time of the announcement to close up 150 points for the day, ending near the 9,600 level. The tech-laden Nasdaq and Standard & Poor's 500-stock index also rallied. Equities hesitated at first after the Fed's announcement, then enjoyed a late rally that dragged the dollar higher late in the session.

LAST BULLET? The initial credit-market reaction was marked by sharp price gains for shorter-dated Treasuries. The 30-year bond pared back earlier gains on the fresh productivity doubts as investors briefly disregarded bonds' scarcity premium (after Treasury's decision in early November to suspend their issuance). And inflation just isn't a worry right now. Two-year yields plunged from 2.48% to 2.34% (bond yields and prices move in opposite directions), while the 30-year bond yield finished unchanged around 4.85%.

Prices of fed funds futures, a trading vehicle market pros use to make bets on the coming direction of interest rates, shot higher, indicating that the market is now factoring in significant likelihood of a further quarter-point cut at the last FOMC meeting of the year on Dec. 11.

The Fed may not be finished with rate cuts just yet. But with the economy facing its greatest crisis in confidence in several decades, it may have just one more bullet left in its chamber. But that may be enough to buy time for an additional $75 billion to $100 billion in fiscal stimulus to be phased in during the first half of 2002. Wallace is chief market strategist for Standard & Poor's Global Markets

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