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Fed Drops Hawk Talk

Stocks rally on rate cut hopes, but bonds tank on inflation fears.

The Fed finally shed its hawkish feathers.

The minutes from the Sept. 18 Federal Open Market Committee meeting, released Tuesday afternoon, reveal that the central bank has grown substantially more concerned about the economic damage wrought by a sinking housing market.

The meeting offers up no familiar reassurances that housing's woes were "contained." Instead, the FOMC minutes reveal the central bank was concerned about weaker job growth in August, weaker retail sales growth, manufacturing production, surveys of business confidence, and a housing sector that remains "exceptionally weak."

The comments suggest the Fed will continue to cut interest rates in coming months. In conjunction with their new view, Fed economists reduced their forecast for fourth-quarter GDP growth and trimmed their forecast for growth in 2008. The Fed also expects unemployment will tick up in coming months.

"The market would gladly forgo a friendly fed for a stronger economy," says Art Hogan, chief market analyst at Jefferies & Co. "But if we're going to get benign economic data at best, or more negative data, then we want to see a friendly fed in the future."

The stock market got the reassurance it wanted. Stocks were essentially flat going into the minutes' release, but the Dow Jones Industrial Average is now up about 75 points, or up 0.5%, as is the S&P 500.

The Fed's stance matches the woes of transportation firms like

Ryder

(R) - Get Report

and

FedEx

(FDX) - Get Report

, which have been lamenting the slowing U.S. economy.

And, while the promise of more rate cuts should boost financial stocks like

Bear Stearns

(BSC)

,

Merrill Lynch

(MER)

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,

Lehman Brothers

(LEH)

,

Citigroup

(C) - Get Report

and

J.P. Morgan

(JPM) - Get Report

, action in the the bond market may mute those gains.

Bond investors fear the Fed has swung too far. The yield on the 10-year Treasury bond rose to 4.66% from 4.61%, as investors sold bonds on concern that the Fed is not worried enough about inflation, says Bill Hornbarger, fixed income analyst at A.G. Edwards. The two-year Treasury note yield is up to 4.12% from 4.07% previously.

"It's a little bit of bond vigilantism," he says. "If the Fed does such an about face and plans to ease more going forward, inflation could become a bigger problem."

After a summer-long seizure in the credit markets, the FOMC reached a unanimous decision to slash the fed funds rate by 50 basis points on Sept. 18 to 4.75%. The Fed had kept rates steady at 5.25% for over a year prior to last month, justifying their inaction by proclaiming inflation was the key threat to the U.S. economy.

On inflation, the central bank reduced its expectations for future inflation and made note of declining prices for prescription drugs, cars, and non-market services. The minutes give a nod to rising hourly earnings, but made no suggestion that inflation was a dire risk to the broader economy.

"In retrospect, the Fed was perhaps a bit too cavalier about risks posed to the overall economy by home price deflation, especially when compared with risks posed by a mild rate of core inflation," says John Lonski, chief economist at Moody's Investors Service.

Indeed, the Fed believed the housing market was showing signs of stabilization in January. Since then, housing starts and permits reached 12-year lows in August, while new and existing home sales reached seven and five-year lows.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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