Fed Can't Give It Away, but It's Getting Close

Most economists expect a half-point rate cut Tuesday. Stocks and bonds rose ahead of the next FOMC meeting.
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The most aggressive rate-cutting campaign in the history of the

Federal Reserve isn't over yet, and stocks and bonds are rallying as the easing is set to continue.

With the economy likely in a recession, expectations for a dismal fourth quarter and a hefty fiscal stimulus package still stuck in Congress, the pressure is on Fed Chairman

Alan Greenspan and the

Federal Open Market Committee to keep the rate-reducing machine in drive. Economists expect the Fed to lower rates for the 10th time this year at Tuesday's meeting.

"It may very well be true that deep in their hearts they don't think there is a whole lot they can do about the state of the economy at this point," said Anthony Karydakis, senior financial economist at Banc One Capital Markets, who ultimately expects interest rates to fall below 2%."But the Fed can't afford to stay on the sidelines in this environment. The reality of what is unfolding is pretty serious stuff," he said, referring to the recent collapse of consumer confidence, the dramatic decline in manufacturing activity in October, soaring jobless claims and the steepest decline in payrolls in 21 years.

The stock market has held up pretty well since late September, as investors look forward to a recovery. The major indices were on the rise again Monday after slightly easing off of their northward course last week. Since Sept. 21, the

S&P 500 and the

Dow Jones Industrial Average are up 13% and the

Nasdaq is up 23%.

Around midday, the Dow was gaining 1% to 9420, the S&P was climbing 1.2% to 1100, and the Nasdaq was up 2.3% to 1786. Treasuries were also trading higher.

Whether the Fed is going to chop a quarter-point or a half-point, and how much more it will cut after that, is a matter of debate. Rates have already fallen to 2.5% from 6.5% at the beginning of the year, energy prices are low, and the long-term impact of low rates has some economists worried about the possibility of inflation eventually creeping into the picture.

A

Reuters

poll on Friday of the 24 primary dealers of U.S. government securities showed that 15 were expecting a half-point cut Tuesday. The other nine firms forecast a quarter-point rate reduction. Before the release of the October

jobs report, which revealed that the nation's unemployment rate surged to 5.4%, dealers were predicting a quarter-point cut.

With so much uncertainty about the direction of the economy, and following two half-point cuts after Sept. 11, some think the Fed will want to move slowly this time around, leaving the option of cutting rates between meetings. Diane Swonk, chief economist and director of economics at Bank One, sees the Fed cutting rates to 2.25% Tuesday, and then to 2% later, but she said rates could fall as low as 1.75% by the first quarter of next year if the economy continues to weaken at the current pace. "We're really walking a fine line between what the economy is today and what the economy is tomorrow," she said. "We're going to see watch-as-you-go monetary policy."

Because nine to 18 months typically pass before the effects of monetary policy are felt, any new rate cuts won't be evident until next year anyway, when economists think growth will recover. Therefore, the only real effect more rate cuts might have would be to boost consumer confidence, Swonk said. "We were dominated by

the need to support consumer confidence on Sept. 17, but we don't need to be dominated by it today unless we see a precipitous drop in the stock market that freezes up liquidity," she said. The Fed cut interest rates by 50 basis points Sept. 17, when the equity markets reopened for the first time after the Sept. 11 terrorist attacks. Stocks tanked anyway, but the losses might have been worse without the rate cut.

Too much action now could make the Fed's job tougher next year. Some economists are forecasting a strong economic recovery, while the government is likely to post budget deficits, which would put upward pressure on inflation. "Around midyear the concern may be that the Fed will clamp down hard with the first sign of recovery because they will have driven short-term rates to very low levels," said Karydakis.

But raising rates may be politically difficult next year. "The risk of lowering rates too much is that they won't be able to raise them again," Swonk said. "While no one likes to think of the Fed as a political body, we're going into a new election cycle."

The Treasury Department's decision last week to stop issuing 30-year bonds should take a little bit of pressure off the Federal Reserve. That move brought down long-term interest rates, which haven't responded to the rate cuts this year. Lower long-term interest rates help spur capital spending, and weakness in capital spending has been responsible for much of the current slowdown.