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The Rate-Cut Express Takes a Rest

By Michael Wallace After Federal Reserve Chairman Alan Greenspan's rare public reversal, switching to a more upbeat assessment of the state of the economy in his Jan. 24 testimony before the Senate Banking Committee, there was little doubt that the Fed would aim to keep things status quo. And that's just what the board's policymakers did in their first gathering of 2002. After an unprecedented 11 consecutive rate cuts, the Federal Open Market Committee left the federal funds target rate -- currently at 1.75%, its lowest level in some 40 years -- unchanged on Jan. 30, following a two-day policymaking session.

After some initial weakness, stocks rallied following the announcement. Fed funds futures, a trading vehicle for market pros to bet on future interest rate moves, are not signaling any return to tightening until the FOMC's June meeting. Following an unexpected gain in preliminary fourth-quarter gross domestic product -- and the associated likelihood that first-quarter growth could also come in stronger than expected -- shorter-dated Treasury issues dipped in price and yields moved higher.

The long bond held up better because of Treasury's announcement that it will conduct buybacks in the quarterly refunding. The U.S. dollar closed on a firmer note.

STILL WARY. The Fed's move virtually closed the book on the swift and deep cycle of rate cuts set off on Jan. 3, 2001 In the end, Greenspan & Co. couldn't ignore the mounting evidence of a strengthening economic recovery into the new year. In deference to a still-frail corporate sector, however, the Fed retained its policy bias toward further rate cuts -- a signal that it's prepared to wait for growth to take root before it shifts back to a neutral bias.

But the Fed has made it clear that it remains vigilant about threats to the emerging recovery. In the briefest post-meeting statement since September, the FOMC cautiously elaborated on the "weakness in demand abating" phrase from its prior press release in December. The Fed suggested that "signs that weakness in demand is abating and economic activity is beginning to firm have become more prevalent."

This sounded a more optimistic note than its description of those signs -- just "preliminary and tentative" -- in the previous statement. And that meshed with recent signals from Fed officials in speeches over the past month.

The Fed was also more upbeat in its assessment that "the outlook for economic recovery has become more promising." Prominent in the list of factors contributing to that brighter outlook was "accommodative" policy, suggesting the Fed will remain on hold for some time to come.

PLENTY OF LIQUIDITY. Indeed, the Fed warned, "the degree of any strength in business capital and household spending, however, is still uncertain." This appears to be a subtle reminder that the bond market could get ahead of itself -- if market rates rise too rapidly, that could undermine the recovery.

Yet, the statement omitted any specific reference to inflation declining, perhaps a nod to the view that long-term prospects for productivity growth are good, and the economy is on track to hit Fed's own long-run goal of price stability. There's little doubt that the central bank will maintain its vigilance on inflation in the coming months.

In just over a year and a month, the Fed has come full circle and stopped flooring the gas pedal. Still, with short-term rates near 40-year lows, liquidity is flowing freely into the economy. Key to the Fed's future policy will be a continuation of positive economic data and further success in the war on terrorism. In the wake of the Enron mess, the capital markets will also need to exorcise their accounting demons -- and corporations return to sustainable profitability -- before investor confidence can fully recover. Wallace is chief market strategist for S&P/MMS International

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