Market Likes Latest Cut

Updated from 2:20 p.m.

The markets appear to hold the winning cards when it comes to the Fed.

The Federal Reserve initially disappointed traders when it slashed its key fed funds rate by just another 25 basis points Wednesday, as expected. It also made a 25-basis-point cut in the discount rate.

But on second thought, investors realized that what appeared to be a neutral statement on the risks facing the economy doesn't mean the Fed won't cut again. The markets were back in rally mode shortly after the 2:15 p.m. announcement.

In the statement accompanying the policy-setting Federal Open Market Committee's decision to cut the overnight borrowing rate to 4.5% from 4.75%, the central bank stated that the "upside risks to inflation roughly balance the downside risks to growth." That, combined with Kansas City Fed President Thomas Hoenig's dissent, preferring to keep the fed funds rate steady at 4.75%, initially suggested to observers that the Fed is not inclined to cut further come December's meeting.

But the Fed's language is hard to trust these days, says James Bianco, president of Bianco Research, noting that the initial reaction to Sept. 18's surprise 50-basis-point rate cut was similar. Economists believed then that the Fed was merely managing the credit crunch crisis, and stopping there. Indeed, the Fed had persistently harangued about the outsize threat of inflation to the economy for a year while keeping the Fed funds rate steady until September.

"Now, the new line seems to be, 'Everything's fine and balanced,' but we're still cutting," says Bianco, adding that he believes the Fed has acquiesced to the markets. Bond yields and the dollar were falling in anticipation of a fed funds rate cut, and stocks were jittery of late at the mere thought that the Fed would not offer more liquidity.

Part of the anxiety comes from hopes that lower short-term interest rates will aid companies like Countrywide Financial(CFC) and Merrill Lynch(MER), which are suffering hefty losses due to tighter lending standards that took hold during this summer's credit crunch.

"We should just change Bernanke's title to chief investment officer of the United States," says Bianco, adding that the markets are never going to relinquish their hope for more rate cuts. "If you cut 75 basis points in two meetings, you don't think everything is fine," says Bianco.

The Fed begs to differ, of course.

"The committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth," reads the FOMC statement, in a near match to September's on the prospect of more easing of monetary policy.

On inflation, the Fed nodded to higher energy and commodity prices, adding more pat language that "some inflation risks remain, and it will continue to monitor inflation developments carefully."

"You can feel the reluctance in this directive," says Ethan Harris, chief economist at Lehman Brothers, who believes the central bank was less convinced than the markets that it would cut rates Wednesday.

Harris believes further cuts will require more proof of economic weakness, though he acknowledges such proof may not be hard to come by.

Tighter lending standards have prevailed since the summer's credit market meltdown, and the housing market has taken yet another leg down this autumn, which paves the way for more rate cuts.

"The problem with the housing story is that you can't see the end of the tunnel," says Harris.

The tunnel certainly doesn't end here. The rate decision comes on the heels of the U.S. government's first assessment of third-quarter growth. At 3.9%, it looks strong, but the details highlight the nation's shift toward a more export-dependent economy that rests largely on the weak dollar, and it indicates little about future growth.

The decline in residential investment, or housing, was a stunning 20.1% in the third quarter, subtracting 1.05 points from growth, while trade added 0.93 points to the tally, aided by another increase in exports. A weak currency and high commodity prices often lead to inflation. While inflation remains within the Fed's comfort zone, as measured by the core personal consumption expenditures measure, it rose to 1.8% in the quarter from 1.4% in the second quarter. The dollar slumped anew in the wake of Wednesday's rate cut.

Since the third quarter ended, growth prospects have weakened. Not only is housing a persistent disaster, but weekly initial jobless claims have increased, while oil prices mark new record highs around $90 per barrel, consumer confidence has fallen, and reports of shipping, orders and regional economic activity have waned. Wednesday, Chicago's regional survey, the Chicago PMI, came in weaker than expected and under 50, marking a contraction in that area's economy.

"The economy carried plenty of momentum into the financial storms which hit in August," writes Nigel Gault, U.S. economist at Global Insight. Gault questions how well the economy can withstand the aforementioned headwinds that took hold after the summer's credit crunch.

"We expect the damage to come through soon," he writes, adding the firm predicts 1.5% growth in the fourth quarter and "no better than that in the first half of 2008."

The Fed appears to agree.

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