Market Focused on Greenspan Speech for Fed Direction

When it comes to the Federal Reserve , it's all become perfectly clear. Now nobody knows what the heck it's going to do next week.

Heading into the Fed's Jan. 30-31 Federal Open Market Committee meeting, there's a legitimate question as to whether the Fed will cut interest rates by 50 basis points or by 25 basis points, although the market still leans heavily toward the former.

Which is what makes Chairman Alan Greenspan's testimony tomorrow before the Senate Budget Committee so significant. Normally, this is one of the Fed head's most important speeches of the year, because it sets the tone for his February semiannual Humphrey-Hawkins testimony and gives people an idea of how he sees the coming year.

This year, it's doubly charged, because he's expected to guide the market as to whether the Fed will indeed cut the fed funds rate target by 50 basis points, following its surprising cut on Jan. 3, which moved the rate to 6%. Economists generally believe a 50 basis-point cut is in the offing, and that Greenspan will talk about the economic weakness.

"I think he's going to emphasize that they're going to keep the expansion going, and that there's some risk that it's slowed too much," says Mark Wanshel, economist and J.P. Morgan Chase's Fed watcher. "The economy weakened dramatically at the end of last year and they may be worried about sluggish growth for the next several months."

Sobering Economic Weakness

Muddying what looked like a clear swim to a 50-point cut was yesterday's article by Fed watcher Steven Beckner of Market News International, which quoted Fed sources suggesting some policymakers think a 25-point cut may be enough, due to recent improvements in the financial markets and continued worry over rising inflation.

But economists believe it would be odd for Greenspan to back away from the grave concerns the Fed expressed in early January, when it felt the economic situation was serious enough to justify an intermeeting cut. That action indicated the committee's desire to stave off recession, and despite the financial markets, economic indicators haven't displayed much improvement, which Greenspan will likely mention.

Since Jan. 3, the market has watched the Philadelphia Fed's Index for the Mid-Atlantic region drop to -36.8, its lowest reading since December 1990, when the economy was in recession. Consumer sentiment is at 93.6, according to the University of Michigan's survey, the lowest reading since June 1996.

"I'm leaning to 50, mainly because most of the economic numbers have been so weak, particularly the manufacturing sector," says David Jones, chief economist at Aubrey G. Lanston, who believes this is a close call. "Most Fed policymakers have been sobered by the unexpected weakness in the economy."

And recent speeches by other Federal Reserve officials, including Fed vice chairman Roger Ferguson and Richmond Fed president Al Broaddus, which, while trying to assuage people that the economy isn't heading into a recession, show a willingness to respond forcefully to economic weakness. Often, other Fed officials will articulate the Fed's general viewpoint prior to a Greenspan address.

Not Two Bits. Four Bits.

Clearly, with two-year note yields at 4.84%, the credit markets are ready for such a rate cut. However, there's always a chance that the Fed could cut by just 25 basis points, with its well-earned reputation for prudence (and 75 basis points in a month is hardly a wimpy response to a slowing economy).

But it's hard to see how Greenspan, in his speech, would convey the Fed's intention to pull back and cut by just 25 basis points. He could (and probably will) cite the recent improvement in credit spreads and a pick-up in activity in the high-yield markets, which suggests that companies are more easily finding financing.

He could also talk about the recent improvements in equity shares as a reason to back off.

But that's risky.

It gives the impression that the stock market was the reason for the rate cuts to begin with. To hinge a smaller rate cut on the markets ignores the fact that the markets' reaction is based not just on the Jan. 3 cut, but on the promise of more cuts.

There are also inflation issues to consider. The Consumer Price Index is rising, and cutting rates to boost demand puts the economy at risk of higher inflation. The core CPI, which excludes energy prices, was lately rising at a 2.6% year-over-year rate. Not bad, but not as good as December 1999, when the rate was 1.9%. Another measure of inflation -- the Cleveland Fed's median-weighted CPI, which cuts out monthly outliers -- has averaged 3.7% over the last three months. That's the highest rate since November 1995, points out Asha Bangalore, economist at Northern Trust.

"It doesn't appear inflation has reached the cycle high yet," Bangalore says. "You have to factor in the enormous buildup we've seen, with or without energy."

But others counter that the Fed still has the freedom to raise rates later if inflation, clearly not the primary issue for the Fed now, continues to rise. The Fed's first priority is avoiding recession and helping the economy rebound.

Greenspan, in his delightful, obfuscating way, should say as much tomorrow.