Rate Cuts: The Door Is Still Open

Yes, there may be more easings after the May 15 move. But the Fed is holding its policy cards close to the vest

By Michael Wallace

It was one of those rare occasions when markets were demanding words and not deeds from their policymakers. But the across-the-board half-point cut by the Fed on May 15 was delivered with some ambiguity as to the final depth of the easing cycle. In general tone, the latest statement from the Federal Open Market Committee (FOMC) was very similar to remarks made following the Apr. 18 intermeeting cut.

Though there were some subtle differences that will undoubtedly be spun a variety of ways, in terms of the policy cycle, the Fed held its cards close to the vest but clearly kept its options wide open.


  As was the case in April, the Fed continued to blame the ongoing decline in capital-equipment spending, the drought in corporate profits, business uncertainty, and slowing global growth for U.S. economic weakness. This time, however, the "unacceptably weak" remark used as the cover for the intermeeting move in April was dropped in favor of a more vague "weigh on the economy" rationale.

This was as close as the Fed came to hinting at a policy pause, though we may be grasping at straws considering that the Fed gave no overt signal that it sees a quick end to this vicious cycle. Moreover, the Fed remained concerned about the "possible effects of earlier reductions in equity wealth on consumption."

Also reintroduced was a statement that inflation is expected to remain contained, especially with the "pressures on labor and product markets easing," which fanned hopes for further rate cuts. Certainly, the sharp steepening in the yield curve suggested that the long end is more worried about overstimulus than the Fed is. Indeed, hikes in energy prices, especially in the West, could be an impediment to much easier policy at some stage, if rising bond yields put a crimp on the resilient housing sector and massive corporate issuance. The April consumer price index (CPI) is likely to be inflated to 0.4% (0.2% core) on May 16 by energy gains, and this could test the bond market's patience with the Fed's equity market favoritism.

Note that the Fed did not include a "monitor closely" statement, which had heralded subsequent intermeeting cuts following scheduled meetings in December and March. Yet, the next meeting on June 26-27 is still some distance away. And that could cause equities some disappointment, despite Tuesday's post-announcement jerk higher, in combination with stiff earnings headwinds and upcoming second-quarter pre-announcements in June.


  In fact, only five Federal Reserve districts requested a cut in the discount rate this time. This compares to requests from eight districts on Apr. 18, the full 12 districts at the Mar. 20 meeting, nine districts at the Jan. 31 meeting, and seven districts prior to the move at the surprise intermeeting session on Jan. 3. It's possible that the lack of unanimity on the discount rate indicates the decision was more contentious than the statement reveals.

The outlook is equally murky. According to Fed funds futures -- a key trading vehicle for market pros to place bets on future fed policy -- the July contract presently discounts a 68% chance of a quarter-point cut between now and then, compared to 20% odds priced prior to the Fed move. The September contract is 80% confident of a 3.75% rate by summer's end, which suggests that the money markets are experiencing a little Fed fatigue.

Yet, ultimately, the central bank left intact its bias of "risks weighted mainly toward conditions that may generate economic weakness in the foreseeable future," which was its clearest statement of intent.

Wallace is a senior economist for Standard & Poor's Global Markets

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