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The Fed's Door: Half Open, or Half Closed

By Michael Wallace The Federal Reserve took another step in its unprecedented rate-cutting binge on Dec. 11 by trimming the federal funds target rate -- the rate banks charge each other for overnight loans -- a quarter point, to 1.75%. It also lowered the discount rate -- what the Fed charges banks for overnight loans -- by the same amount, to 1.25%.

This marks the 11th easing this year by the Fed's policy-setting arm, the Federal Open Market Committee. During 2001, it has cut rates a total of 475 basis points. The fed funds rate now stands at its lowest level since July, 1961.

In the statement accompanying the move, the policymakers left the door open to further easing, implying that the FOMC will await more concrete evidence of economic recovery before going to "neutral." But the end of the cutting spree may be in sight. The FOMC adopted language in the statement suggesting that Alan Greenspan & Co. is nearing the end of its easing rope.

SUBTLE SHIFT. In most respects, the policy announcement was markedly similar to those that accompanied the three previous easings. The terse statement mechanically presented its case in four paragraphs: one each for the rate action, the policy rationale, the productivity outlook, and regional Fed requests for the discount rate action. However, a subtle shift occurred in the key second paragraph, one that could be taken as a signal that the Fed is preparing the markets to accept an end to the easing cycle.

Instead of referring to deteriorating business conditions "damping economic activity," a phrase repeated in the past three statements, the Fed introduced a more qualified assessment. "To be sure, weakness in demand shows signs of abating, but those signs are preliminary and tentative," it said. This may suggest that the Fed is shying away from further cuts, though it still characterized the underlying economic activity as "soft."

At this point, though, while the Fed seems ambivalent about economic prospects, it must recognize that further short-term rate cuts could risk igniting inflation, driving the yield on the 30-year Treasury bond even higher from its current 5.5%. The higher long-term rates move, the more expensive borrowing becomes for businesses and consumers, at some point slowing the progress of an economic recovery.

HOLDING STEADY. However frustrated they may be, the policymakers aren't likely to try to make up for Congress' lack of progress on the economic stimulus package. So the best bet for the Fed -- the one with the lowest risk and highest payoff -- may be to hold rates steady at this low level until the recovery finds its own legs next year.

And the Fed itself sees the forces that could help foster an upturn. It's still banking on long-term productivity gains (adjusted slightly downward to reflect a reallocation into homeland- and corporate-security spending), and it sees "underlying inflation likely to edge lower from relatively modest levels," which may buy some time for rates to linger at 40-year lows.

And by maintaining its now-famous policy position that "the risks are weighted mainly toward conditions that may generate economic weakness for the foreseeable future," the Fed leaves the emergency exit ajar to adjust for the unexpected.

WEAKER BUCK. The market's reaction was muted. While stocks rose on Dec. 11 following the announcement only to weaken into the close of trading -- the Dow Jones industrial average posted a modest loss, while the Nasdaq managed a slight gain -- short-term Treasury notes rose in price. Also, the 30-year bond initially climbed over a point higher but then relinquished much of those gains by the session's close. The dollar weakened after the announcement.

What does the market see next on the rate front? Prices of fed funds futures, a trading vehicle market pros use to bet on whether rates will rise or fall, moved marginally higher, in line with initial price gains of shorter-dated Treasuries in reaction to the cuts. The February funds contract is tentatively discounting about a 40% probability of another quarter-point cut, covering the period through the next FOMC meeting on Jan. 29 and 30.

Contracts for later months, however, are registering only about a 20% chance that the Fed eases again next year. That's a sign that the market is looking for a floor in the easing cycle in the not-to-distant future. Wallace is chief market strategist for Standard & Poor's Global Markets

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