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Contemplating the Fed's Encore

The bond markets may be assuming that this is the end of the Fed's easing cycle.

Now that the much-anticipated


meeting is out of the way, we can thankfully turn to other matters, such as: What does the central bank do



Yes, believe it or not, the path of future policy action was a hot topic in the immediate aftermath of the Federal Open Market Committee's decision Wednesday. Critically, there was some discussion that the quarter-point rate cut will be the Fed's last of this cycle, assuming no unforeseeable negative shocks emerge.

"Unless we slip over into net deflation, 'corrosive deflation,' I can't see them doing a whole lot more," said Jeffrey Saut, chief equity strategist at Raymond James. "They've destroyed the money market industry

and killed the retirement community by forcing them up the risk curve."

Concern about disruptions to the money market industry -- where expense ratios often approach or exceed the now-1% fed funds rate -- was one reason commonly cited for the Fed's decision to opt against a 50-basis-point cut this week. Such considerations will remain prominent if and when the Fed next contemplates rate cuts, be it at the Aug. 12 FOMC meeting or some other juncture. So too will any political considerations about those Americans living on fixed incomes. (Not that politics plays a role in Fed policy, of course.)

Also, Saut noted the fed funds rate hasn't been below 1% since the Great Depression, suggesting "Sir Alan will not likely want to be remembered as the Fed head who lowered interest rates below those of the 1930s Depression era." (On a related note, there is a psychological risk of lowering the fed funds rate below 1%, lest more investors contemplate a zero-rate environment.)

More than historic comparisons, fixed-income participants focused on the

policy statement accompanying Wednesday's rate cut. Specifically, the central bank's declaration that the balance of risk facing the economy is "roughly equal" between upside and downside.

In effect, the Fed "removed the bias toward easing that had been

previously incorporated in its policy directive," said William Sullivan, senior economist at Morgan Stanley.

Wednesday's sharp selloff in Treasuries reflected rising expectations that the Fed will now stand pat for the foreseeable future. Prior to the meeting, expectations were that the central bank would either cut by 50 basis points Wednesday or by 25 basis points and another 25 basis points in August. "Now, you must calibrate for a 1% fund rate through summertime, perhaps into fall," he said. "That's one reason the bond market

sold off."

As detailed

here, Sullivan is skeptical that the signs of economic improvement cited by the Fed will prove sustainable. But "I have to be flexible

and respect the Fed's sense that evidence pointing to improvement will ultimately be reflected in government statistics," he said. "There is a lot of stimulus in place -- fiscal and monetary -- and in the past the economy has responded to huge infusions of liquidity."

TheStreet Recommends

Clearly, many equity market participants are betting that the combination of tax cuts and aggressive monetary policy will be sufficient to propel the economy into a more robust recovery. Stock traders didn't seem overly concerned Wednesday by the Fed's decision, and many suggested that 25 or 50 basis points wouldn't have made much difference. Following the afternoon selloff, many traders reassured themselves that quarter-end window dressing will provide the market a short-term boost, regardless of what the Fed did or didn't do Wednesday.

Who's Got Next?

In some regard, the relevant question for financial markets is when the Fed next contemplates


rates, and "they didn't give any indication that's in the foreseeable future," observed Paul Kasriel, chief U.S. economist at Northern Trust in Chicago.

Indeed, the Fed repeated a warning that "the probability, though minor, of an unwelcome substantial fall in inflation exceeds that of a pickup in inflation from its already low level." In a new twist, the Fed said that relationship "is likely to predominate for the foreseeable future."

However remote the Fed views the threat of deflation, the central bank is highly unlikely to tighten if it sees any possibility of prices spiraling downward, leading to weaker economic activity.

Kasriel wondered how the Fed expects economic growth to resume -- or even exceed -- its trend rate of around 3% if the inflation rate is going to fall further. The current annual rate of inflation is 1.6%, according to the core consumer price index. "If the core falls to 1% in the next six months, that means the 'real' fed funds rate is going up," Kasriel said, referring to the inflation-adjusted fed funds rate. "They're going to be

effectively tightening policy as this recovery starts to take shape, which could abort the recovery."

Of course, such a scenario assumes inflation doesn't rise in the coming months. Most of those critical about the Fed's decision Wednesday agree deflation is a more imminent risk and, therefore, a 50-basis-point ease would have been more appropriate.

The quarter-point cut "runs counter to the Fed staff's

own conclusion from the Japanese experience that monetary policy should act early and aggressively if deflation is a risk," as Goldman Sachs economist Jan Hatzius wrote. (Goldman had forecast a 50-basis-point cut and still expects the fed funds rate to fall to 0.75% by the end of the third quarter.)

At the other end of the spectrum, Richard Bernstein, chief U.S. strategist at Merrill Lynch, suggested that the more the Fed eases, the greater the chance of deflation.

"The Fed's actions continue to lower the cost of capital for the marginal company, which serves to support the economy's overcapacity," Bernstein wrote. "Our concern is that investors will soon be calling Mr. Greenspan 'Greenspan-san' for his Japanese-like strategy of keeping overcapacity alive."

The oft-bearish strategist argued the next "fundamentally based bull market will probably begin when it becomes apparent that the Fed needs to tighten." Bernstein's rationale is that the Fed won't need to tighten until the deflation threat has passed and the economy has transitioned into more mature and sustainable growth. "Clearly that is not the present situation," he said.

Just as clearly, Bernstein is of a minority view on Wall Street in thinking more cutting is a


thing. The weakness in financial markets on Wednesday -- especially in Treasuries -- reflected traders' concerns that the historic easing cycle that began in January 2001 finally may be coming to a close.

In some regard, that's a "good" thing for those long because it shows traders maintain faith in the power of Fed easing. The bad news, of course, is traders maintain faith in the power of Fed easing, despite its limited potency in recent years.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.