Let's Hope the Fed Knows When to Stop

Indications are growing that rate cuts have foiled a recession. Now it's time for Greenspan & Co. to back off

By Christopher Farrell

O.K., so the past several months have been abysmal. Corporate profits have plunged, job losses have skyrocketed, and the vital technology sector has stumbled badly. Little wonder the Federal Reserve Board has boldly cut its benchmark interest rate from 6.5% to 4% in five moves over a scant four months.

But look at the financial markets: They are now predicting that the central bank's aggressive campaign to stave off a recession in the second half of the year will work. The markets are also telling the Fed that its job is done. The central bank should now shift tactics and stay the course from here on out.

Certainly, the recent gains in the broad-based stock market indices suggest that the earnings outlook is no longer deteriorating and may even improve. Even more important is the optimistic message coming from a traditional bond-market indicator of the economy's direction: The shape of the "yield curve."


  It's among the most reliable forecasters of the economy. When long-term bond yields are substantially above short-term rates, investors are anticipating a rebound in the economy, and vice versa. The difference between 2-year and 10-year Treasury notes has widened from 36 basis points four months ago to 123 basis points today. (A basis point is one-hundredth of a percent). The yield curve is steep enough that bond investors are expecting a classic "V" shaped upturn in the economy, says Stephen Roach, chief economist at Morgan Stanley.

To be sure, the Greenspan Fed accompanied its May 15 half-point rate cut with an announcement that it stands poised to ease again. Much of the commentary I've read in recent days from Wall Street economists and market strategists assumes another rate cut by the central bank in June -- at least a quarter-point and possibly another half.

Yet it seems we are at a critical juncture where the chatter on Wall Street will soon shift from worrying about prospects for a recession and a bear market to fears over inflation and irrational exuberance in the stock market. While the latest inflation data are encouraging, the Fed has eased more aggressively this year than it has in nearly 20 years. The Fed risks upsetting the volatile financial markets if it makes one ease too many, warns Edward Yardeni, chief investment strategist at Deutsche Banc. Alex. Brown.


  Indeed, with the exception of a handful of forecasters prophesizing a U.S. depression, such as John Makin of the American Enterprise Institute, the gap between cautious optimists and relative pessimists now turns out to be a matter of months. Yes, that time difference matters greatly to the millions of workers who will either keep their jobs or lose them, depending on whether the economy skirts a recession. The exact timing remains murky, but the markets are saying it won't be long before jobs and incomes start climbing higher.

Put it this way: The odds are strengthening that the longest U.S. expansion in history, now in its 11th year, will remain intact. Monetary policy is always a gamble, and the art of the central banker is to know when to hold and when to fold. The Fed should hold now and keep holding.

Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online

Edited by Beth Belton

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