Who Made Who? Fed's Decision Puts the Market Front and Center

This rate cut had something in it for everybody.

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Commentary

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Market Reaction

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Perspective

Fed Moves and the Market: The Charts

Why Did the Fed Cut Rates Today?

Today's 50-basis-point move by the Federal Reserve acknowledged a significant slowing in the economy, one that seems to have surpassed economists' projections. It is also likely to alleviate tight credit conditions, which have made it hard for borrowers to get badly needed cash.

But economists and market observers believe public perception has more to do with the Fed's surprising action today than anything else. Now, when more than half of all American households own stock in one form or another and Alan Greenspan has achieved celebrity status, it's clear that the Fed, while acting prudently and reacting to the economy, is also mindful of its own perception within the economy and investment community.

Today, in one fell swoop, Greenspan and company have entirely changed the market's perception -- to the tune of 300 points on both the Dow Jones Industrial Average and the Nasdaq Composite Index . But with that comes the danger that unwavering optimism will march back into the market or that Greenspan has saved the market again, as he did in 1998, when Russia's credit-driven crisis caused the seizing of the bond markets and the market dropped sharply.

Eyes Wide Open

Clearly, there was merit to this rate cut.

Whereas from July 1990 to October 1990, the Conference Board's index of consumer confidence fell nearly 40 points and the Fed responded very slowly, that index has dropped 14 points in the past three months. Plus, the National Association of Purchasing Management's purchasing managers' index registered its fifth reading below 50, indicating a contraction in U.S. manufacturing activity.

But today's move was clearly not done for just economic reasons but also to manage public perception of how the economy is doing. The initial reaction, obviously, is that the Fed has once again come to the markets' rescue.

"It's emotional," says Norbert Ore, chairman of NAPM's survey committee. "There's a confidence factor it brings back. There's more impact than the interest rate lowering itself. It sends the word to the consumer that the likelihood is we've come very close to the bottom [for the manufacturing sector]."

But the perception that the Fed needed to drastically assuage the market raises the question as to whether it will feel compelled to engage in even more coddling should the stock market turn south after the expected lousy crop of earnings results this month. Already, there are pundits arguing that the Fed is going to have to cut rates again on Jan. 31, and possibly by another half-point by the middle of the year.

"They're counting on turning psychology," said Mike Niemira, economist at Bank of Tokyo-Mitsubishi. "The Bush Administration is talking recession; the news flow is impacting everybody and you're seeing those stories get built in, and so there's this strong statement to turn psychology around quickly."

Feast or Famine?

The problem with charging the Fed with changing the market's entire perception is that today's action can be interpreted two ways. The Fed not only undertook the unusual move of cutting rates 50 basis points between meetings, the first time it has done that since 1992, but it released a rather alarming statement, alluding to "lower consumer confidence, tight conditions in some segments of financial markets, and high energy prices sapping household and business purchasing power."

"Certainly, the message gave an almost dire picture," says Niemira. "You read that and you think, 'Jeez, is the sky falling down?' It painted a pessimistic picture on a lot of fronts."

It's possible to interpret this as implying a degree of panic here, rather than serving as a calming influence. If the economic environment has deteriorated to this point, there's still a chance the economic situation will worsen, despite the Fed's actions. If the market's out there thinking of the Fed as the savior, there's a rude awakening awaiting if it turns out not to be 1998, when the crisis was largely one of liquidity that basically just needed a soothing hand.

Not only did market psychology reverse rapidly in 1998, but once the expected credit crisis was averted, the economy, already plugging along quite nicely, soared, creating 1999's asset bubble. This time, the economy is slowing, credit is deteriorating and energy prices are higher. Those factors are working against growth, even as short-term interest rates are more favorable.

On the other hand, if the Fed is indeed pressing the panic button, it is once again just following the markets, which panicked several months ago, some say. With the markets seriously clamoring for relief during the past several months, today's action by the Fed could be viewed as prudent. Tony Crescenzi, chief bond market strategist at Miller Tabak, says Fed rate cuts generally precede the final stages of a bottoming in the equity markets, that the major indices generally rise significantly once the Fed begins cutting interest rates.

"It's part of the process of bottoming; this should work toward creating a series of events that spell the bottom," Crescenzi says. "If the economy improves and corporate earnings improve."

That would argue that the change in perception is enough -- for now.