Cutting Spree May Dull Fed's Blade

Greenspan's rate-chopping chain saw risks running out of teeth before the economy comes around.
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SAN FRANCISCO -- As was nearly a foregone conclusion, the

Federal Reserve

lowered its target fed funds rate today for the 10th time this year. Somewhat controversially, the Fed lowered rates by 50 basis points, bringing the fed funds target to 2%, the lowest since 1961.

Fed funds futures had priced in 65% odds of a half-point move, but the action was controversial because it has suddenly dawned on some market participants that the Fed is running out of room for additional rate cuts.

I say "suddenly" because way back in

February, I likened Fed chairman Alan Greenspan to a stoker in an old-fashioned coal-fired locomotive, furiously shoveling coal in an effort to get the "train" (aka the U.S. economy) up a steep hill.

"If Greenspan continues on such a course, one risk is that he uses up all the coal before the train reaches the crest," I wrote in February, when Greenspan had 550 "shovelfuls" left. Now he has 200, and some market participants are getting antsy, given that the economy is losing momentum even as it hits what is, hopefully, the steepest point of the hill.

"It's definitely a growing concern because we've read numerous articles in the last eight to 10 weeks drawing parallels to Japan," said Marie Schofield, who manages $850 million in fixed-income assets for Fleet Asset Management, including the

(GHQTX)

Galaxy High Quality Bond fund.

The Fed "has to be careful

because you have less room to maneuver the lower you go," she continued. "I think they feel they want to give the market what it wants, but the market can only ask for 50 basis points for so long."

Schofield conceded the Fed is in a tough spot because it "wants to be seen as being forceful at the

presumptive trough," and that monetary authorities are "pulling out all the stops" to prevent the last remnants of economic strength -- consumer spending and the housing market -- from destabilizing further. (Regarding "monetary authorities," she included the Treasury Department and its decision last week to eliminate the 30-year bond as part of the effort.)

But the Fed's

acknowledgment that risks remain weighted toward economic weakness "for the foreseeable future" is disconcerting to Schofield because "they only have 2 more percentage points to go" before fed funds is at zero. Meanwhile, "countercyclical forces are eroding growth, and the economy is not going to turn on a dime even with this much stimulus," she frets.

The risk, then, is the Fed could run out of ammo before the economy turns. Clearly, the central bank has other tools at its disposal, including regulation of money supply and the ability to conduct open market operations in currency markets, leading one source to quip that it's "stupefying" to be worrying about such issues.

Nevertheless, such a development could have nasty implications for consumer and investor confidence, particularly because many equity investors remain convinced that lower rates will be the "magical elixir that will reaccelerate the economy," as Kent Engelke, capital markets strategist at Anderson & Strudwick in Richmond, Va., commented this morning, in anticipation of the Fed's move.

As was the case with rate anticipation yesterday, investors bought stocks today in the wake of the Fed's action, helping major averages overcome modest early losses to close solidly higher: the

Dow Industrials

rose 1.6%, the

S&P 500

gained 1.5% and the

Nasdaq Composite

climbed 2.3%.

Despite her concerns about Fed policymaking, Schofield does not believe the U.S. economy will suffer the same deflationary fate as Japan. For the record, I agree and the October auto sales data show the U.S. consumer is very willing to be tempted by cut-rate financing. Fleet's economists predict the economy will show "marginal growth" beginning in the second quarter of 2002; should that occur, Schofield expects to take her cash position to a minimum and begin adding more "spread product," i.e., corporate and asset-backed securities.

But that's assuming no additional "destabilizing events" occur, she said, noting the "range of uncertainties is huge."

Currently, Schofield's funds remain defensively positioned, with a neutral duration and overweight positions in highly rated corporate debt and U.S. Treasury securities. Her funds produced an aggregate total return of 10.12% this year through 0ct. 31.

It's All Good? Part 2

Engelke didn't directly address the running-out-of-ammo issue but commented "a 40-year low in fed funds made in only 10 months is not a good sign. It is suggesting that really bad things are and will continue to occur."

Although investors clearly remain enamored of the presumptive healing powers of Fed rate cuts, "the consumer did not lead us into this recession, capital spending did," the strategist noted. "Capital spending is not an interest rate-driven decision, it is a profit-motivated choice. Essentially, the FOMC is treating pneumonia with aspirins. It might make us feel better for a short period of time but it does not cure the problem."

Engelke isn't one, but he effectively expressed the mantra of the hard-core bears. In an indirect reply to

last night's column, John Mesrobian of Constantinople Advisors commented via email today: "We are very bearish for good reasons. Fundamentals are terrible and the numbers are getting worse every day.

Real earnings are nonexistent. They may try to prop up the market but history proves they will all fail if there are no fundamentals or

a solid foundation."

According to Mesrobian, there is simply no reason to buy stocks here.

But at least for the short term, the optimists have regained control. Alan Greenspan is betting they can keep the market -- and thus consumer spending -- afloat until Fed and other government stimuli produce some tangible economic recovery, instead of just the hope thereof. Those buying stocks today best pray he's right.