The Fed's Big Mistake ... Too Much Too Soon

Last night I laid out a host of reasons why the Federal Reserve would not ease prior to its meeting on Jan. 30-31. Obviously, I should have said why they should not ease, because the Fed dropped its Fed fund rate a shocking 50 basis points Wednesday, lowering the discount rate by 25 basis points.

Today's Coverage

The Fed's Big Mistake ... Too Much Too Soon

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Cramer Special: The Fed's on Your Side Now

Big News From the Fed! What's It Mean for the Long-Term Investor?

Rate Cut Spurs Tech, but Has the Economic Horse Left the Barn?

Nasdaq Soars on Rate-Cut Euphoria

Fed Move Slices into Options Prices, At Least for Today

Pulse: Giddy Tech Investors Give Life to Beaten Up Chip Stocks

Why Did the Fed Cut Rates Today?

Long End of Treasury Market Battered Following Rate Cut

Fed Scorecard

Between bites of crow sandwich and wiping egg off my face, I can't help but come to the same conclusion: That they should not have done this.

Of course, that doesn't change what they did, nor its positive influence on equities. The Dow Jones Industrial Average rose 2.8%, the S&P 500 gained 5.0%, and the Nasdaq Composite soared 14.2% -- the biggest percent move in its history and biggest point move (up 324.82) ever.

Moreover, trading volumes set records in both Big Board and over-the-counter trading, and advancers far outpaced declining issues in both markets.

They Shouldn't Have Done It, Alice

Because the move wasn't shocking -- Fed fund futures had predicted a 60% chance of an intermeeting rate hike -- the Fed might not get the maximum bang for its rate-cutting buck, as David Jones of Aubrey G. Lanston predicted might occur Tuesday night. That remains to be seen.

Second, the 50 basis-point rate cut before the release of Friday's employment report got people wondering what the Fed is really worried about. Maybe it's something other than "further weakening of sales and production ... lower consumer confidence, tight conditions in some segments of financial markets, and high energy prices sapping household and business purchasing power," as the Fed's statement declared.

It makes me and others wonder -- Is there a financial institution in danger of insolvency, or is the entire system at risk -- as was the case in the fall of 1998 when the Fed last adopted an "emergency" rate cut? Is the U.S. economy already in a recession? Is Japan's in a depression?

The only way the Fed would ease prior to Jan. 30-31 "is if there is some development in the financial market that would warrant it -- a capital market development like a junk bond default or unforeseen development in the equity market," Kathleen Camilli, director of economic research at Tucker Anthony, said in an interview Wednesday prior to the Fed's announcement. "Anything is possible, but I don't see a reason to show the world you're panicking."

After the fact, Camilli said simply in an email exchange: "They panicked."

Unless there's another Long Term Capital Management lurking around out there, a third reason why cutting today was a bad idea was that it wasn't necessary.

"The economy excluding Nasdaq doesn't look nearly as bad as everyone pretends it looks," said Jim Bianco, president of Bianco Research in Barrington, Ill., noting the vast predictions of doom coming from economists, politicians and pundits. "We've priced in a rerun of the Depression, and it's impossible to meet those expectations."

Fiscal policy is likely to be stimulative if and when tax cuts are approved, Bianco noted, mentioning reports that Democrats are also working on tax-cut proposals because they don't want to be seen as hampering the "recovery." (Apparently, George Bush is smarter than is generally presumed.) Add tax cuts to the potential stimulus of refinancings due to lower rates, plus easier monetary policy, and there's a possibility of a rerun of 1998, he said. "Everyone got worked into a fit and stimulated the economy, and it didn't need it."

The economy soared after the Fed's rate cuts in 1998, peaking with GDP growth of 8.3% in the fourth quarter of 1999.

Clearly, few equity investors would fret over a repeat of 1999. While bonds suffered their worst total return year in a decade, Bianco submitted even fixed-income investors wouldn't mind a repeat because spreads will likely narrow, bringing the junk bond market back from the abyss.

As appetizing as that might sound, the researcher noted that the Fed's rate cuts in the fall of 1998 came with inflation running around 1.5% -- vs. 3% today.

"If we pump the economy back up with 3% inflation, you could have 5% in 18 months," he said. "If the Fed is wrong and overdoes it, in 60 days the market might want the Fed to tighten."

It should be noted those comments came before the Fed took action, but that Bianco expected a rate cut prior to Jan. 30-31, if only because it was being predicted by Fed fund futures.

"I have found that [neither] I nor any living person can predict the Fed better than the Fed funds futures contract," he said. (Notably, even those predicting a Fed ease prior to Jan. 30-31 were expecting "only" 25 basis points.) The futures are such a good predictor because the Fed is aware its own forecasts have done "an abysmal job of predicting the economy" and thus "just does what the market tells them to do," he continued. "The Fed is not going to defy what the market wants."

In other words: The inmates are running the asylum. It's pretty clear that's a bad idea, isn't it?

The Fallout

That said, it doesn't change the fact this is good news for those long equities, at least for the immediate future.

"This is a seminal event," said Scott Bleier, chief strategist at Prime Charter. "The Fed keeps pouring concrete under this market."

The current tendency among investors to sell into rallies will soon be replaced by a revival of the buy-the-dip strategy, Bleier said, reinforced as the Fed continues to ease in the coming weeks and months.

Alan Greenspan "doesn't care about the moral hazard," the strategist said. "He cares about the economy and market psychology. The market needed some Prozac after 12 months of manic-depression."

Oh yeah, my old favorite; moral hazard -- the final and biggest reason the Fed made a mistake today.

"There is no Fed policy in this country," Bianco declared in a post-Fed interview. "If this isn't a panic, I don't know what is."

From the bond market's perspective -- where prices fell and yields rose despite the rate cuts -- "as much as the Fed says this had nothing to do with the stock market, it had everything to do with the stock market," he determined. "Every time from here on forward the Nasdaq plunges back to its lows this a.m., expect another 50 basis-point move."

While essentially in agreement with Bleier's "concrete floor" scenario, Bianco's assessment of it was far less constructive. The Fed has "drawn a line in the sand" and now must continue easing every time the Comp falls below 2500 "until we either have a new leg up in the Nasdaq or we've got a fed funds rate at zero," he concluded.

If that sounds fanciful, consider Japan's experience after its asset bubble burst in 1989-90. That led to nearly a decade of increasingly stimulative monetary policy by the Bank of Japan, culminating in the now-infamous "zero-interest rate policy" of the late 1990s. U.S. investors definitely don't want a repeat of that experience.