Federal Reserve Policy Makers Are Facing Less-Fearful Times
 by Greg Ip

WASHINGTON -- When Federal Reserve policy makers meet next week to decide whether to cut interest rates again, and if so, by how much, they will confront a world that looks a lot less scary than when they first cut rates three weeks ago.

Indeed, the gloom has lifted enough that markets are divided on whether the Federal Open Market Committee, the Fed's policy-making body, needs to trim rates by a half percentage point, as many economists expect, or by only a quarter point, when it meets Tuesday and Wednesday.

Fed Chairman Alan Greenspan may drop some hints when he speaks on budget matters before a Senate committee Thursday.

On Jan. 3, the Fed lowered its target for the federal-funds rate to 6% from 6.5%, and indicated the risk of economic weakness outweighs that of inflation. Since that move -- made, unusually, between FOMC meetings -- prices for stocks and corporate bonds have risen strongly. Weekly retail sales have recovered from their dismal December showing, and weekly claims for unemployment insurance have dropped.  

"It might not be the wipeout we thought was occurring in December," says Jerry Jasinowski, president of the National Association of Manufacturers.  

But, he maintains, "Manufacturing is in a recession and the rest of the economy is on the verge of recession." Indeed, since Jan. 3, surveys show manufacturing activity in the Northeast and consumer confidence have slid further, and the unfolding energy crisis in California poses a threat. Many economists think the downside to cutting too little outweighs that of cutting too much.

With a half-point cut, says Ethan Harris, senior economist at Lehman Brothers, "the worst that could happen would be three or four months later the Fed has to reverse some of that easing. And the equity market has a long way to go before you start worrying about bubbles."

Fed governors and regional bank presidents who have spoken publicly since the Jan. 3 move have been optimistic that the economy is not in recession, but, significantly, have made little if any reference to inflation risks. Indeed, the Labor Department said last week that excluding the volatile food and energy sectors, consumer prices rose just 0.1% in December. Additional inflation insight may be gleaned from thefourth-quarter employment cost index to be released Thursday. 

While next week the Fed may choose not to lower rates at all, that is considered unlikely. In the futures market, investors are pricing in 100% certainty of at least one quarter-point cut and 80% probability of an additional quarter point. The fed-funds rate, charged on one-day loans banks make to each other, influences many commercial and consumer rates, such as the prime rate.

The Fed's first move has clearly worked wonders in the financial markets. Since the day before the move, the Wilshire 5000 index of most U.S. stocks is up 7%, more than it rose in the three weeks after the Fed first cut rates in 1990, 1995 and 1998, according to MarketHistory.com. And that is in the face of disappointing profit news from the likes of Texas Instruments Inc., Dell Computer Corp. and Home Depot Inc. 

Bond Investors Return

Corporate-bond yields have also dropped more than they typically have after the Fed starts reducing rates, fueling a huge surge in new borrowing. Last fall, San Francisco apparel maker Levi Strauss & Co. had to scrub a planned $350 million debt issue because investors didn't want to "make substantial commitments," said Treasurer Joseph Maurer. "It was pretty grim." But after the Fed cut rates, investors' appetites returned, and two weeks ago, Levi Strauss sold about $500 million of securities, with yields one to 1.5 percentage points less than it would have paid in the fall. Mr. Maurer praises Mr. Greenspan's quick action.

In explaining their Jan. 3 move, FOMC members cited "tight conditions in some segments of financial markets." Thus, the subsequent revival of stocks and corporate bonds "has got to make them feel happier," says Bill Dudley, head of U.S. economic research at Goldman, Sachs & Co., though he notes that the market for short-term corporate debt appears more skittish. But the fact that the markets "trust the Fed ... implies the Fed has to do what it has to do," i.e. keep cutting.

Indeed, despite rays of hope, the underlying economy still looks fragile. Although the Redbook survey said retail sales were up a seasonally adjusted 2.4% in the first three weeks of January from the same period in December, analysts suspect that may be due to bad weather that pushed some postholiday purchasing from late December into early January.

"The stores appear overweight with inventory," says Todd Slater, an analyst at Lazard Freres. "The markdowns, anecdotally, seem quite high."