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The Great Rate Riddle

So what'll it be, Alan, 25 or 50? While we at MMS International are maintaining our forecast that the Federal Reserve's policymaking arm, the Federal Open Market Committee, will cut the Fed funds target rate by 25 basis points on June 25, recent developments have given some ammunition to those who believe Greenspan & Co. will opt for a double dose, an easing of 50 basis points (see BW Online, 6/17/03, "Don't Bet on a Supersize Rate Cut").

One reason for the change in thinking was the June 19 release of a lackluster update on June manufacturing conditions from the Philadelphia Federal Reserve Bank. While the Philly Fed index improved to 4 on the month, from -4.8 in May, data contained in the report were disappointing relative to the market's much more optimistic expectations of a rumored rebound of 20 to 25, similar to the outsize gain seen in the recent Empire State manufacturing survey.

PAPER TRAIL. The other was an article on that date by the Washington Post's Fed-watcher, John Berry, which said the central bank seems more likely to cut 50 basis points next week "as a sort of exclamation point." Berry thinks such a move will emphasize that Fed officials "believe this will be the final step that, coupled with the income tax cut that will show up in workers' take-home pay next month, will put the economy on a strong, sustainable growth path."

Though Berry didn't note any "Fed sources" behind his forecast of a 50-basis-point move, the article's timing is what stood out the most. It came after the market started to price out the extra 25-basis-point cut following the June 17 release of the consumer price index for May, which showed a greater-than-expected rise of 0.3% in the core rate (which excludes food and energy prices) on the month. It will be interesting, and probably telling, if other media pick up the story line on the 50-point story. That could be a signal that the Fed is trying to get the word out.

Fed-watchers contacted by MMS had mixed opinions regarding the Berry article. While only one of our contacts' outlooks had changed, to a half-point cut from the originally anticipated quarter-point, none of them said they would be surprised to see an aggressive easing.

GREATER EXPECTATIONS. Futures-market players are becoming increasingly convinced, however. Prices of Fed funds futures, a trading vehicle for market pros to bet on the future direction of interest rates, extended gains on June 19, following the release of the Philly Fed index. The July futures contract now reflects about a 70% likelihood of a second quarter-point move on top of the already priced-in and widely expected 25-basis-point easing -- right back to where market expectations were before the June 17 CPI release caused a dip to around 40%.

At this rate, the market will have fully discounted a 0.75% Fed funds target by the conclusion of the FOMC meeting on June 25. Like it or not, the FOMC may have no choice but to accommodate expectations. Indeed, now it looks like it'll be up to the inflation hawks on the committee to invalidate such a move.

In that vein, traders will keep an eye on media reports on Friday, June 20, and over the weekend to contradict or corroborate the Berry article. The absence of any outright repudiation of the 50-basis-point move could suggest at least tacit approval from the Fed of the more aggressive easing expectations. From MMS International analysts

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