The Market Response to Fed By Tony Crescenzi RealMoney.com Contributor 9/18/2007 11:59 AM EDT

A 25-basis-point cut is arguably what is best for the stock market, although the knee-jerk response would likely be down. A smaller cut would be better primarily because a larger cut could create unreasonable expectations and boost inflation expectations.

The notion that a 50-basis-point cut would push the Fed into the realm of "what do they know that we don't know" and, hence, hurt the markets is an odd one, since a larger cut would reduce the prime rate by a larger amount and, hence, reduce interest costs for millions of borrowers, including some facing mortgage resets.

The only credence for the view that 50 would spark fears about what the Fed supposedly knows is in the early going. More important is the fact that a 50-basis-point cut could boost expectations for future cuts and raise inflation fears.

In gauging the possible stock market response, it is very important to note that the stock market has rallied despite the bond market having shaved 30 basis points from rate-cut expectations in a week. The rally likely has occurred because the stock market would rather see a stable credit market, which has been seen of late, and a better economy as opposed to having a 50-basis-point cut and the reverse on the credit markets and the economy.

The fact that stocks have gained whilst removing future cut hopes shows it can handle a slower speed of cuts, so long as the slower speed is in response to more stable credit markets and a better economy. A 25-basis-point cut also helps to contain inflation expectations, generally a positive for the equity market.

A large cut in the discount rate would most likely be seen as a positive because it would broaden the safety net thrown on Aug. 17 when the Fed first cut the discount rate and help address lingering concerns about short-term liquidity.

Cutting the discount rate has no impact on borrowing costs, since most debt obligations are tied to the prime rate and LIBOR, to which the discount rate has no direct impact.

Inflation expectations would not likely increase with a larger discount rate cut because the cut would have virtually no bearing on money-supply growth unless discount-window borrowings rise meaningfully.

With a 25-basis-point cut, what will be important is for the Fed to leave the carrot dangling. No one expects the Fed to outright say, "We will cut again at the next meeting," but what is expected and what is needed to maintain the improved tone in markets is a sense, however conditional it may be, that there could be more cuts "if necessary."

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Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of the revised investment classic, The Money Market, first published in 1978 by Marcia Stigum, and The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback; click here to send him an email.

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