Alan Greenspan and the Fed, by cutting rates a half-percentage point four weeks earlier than investo...
Alan Greenspan and the Fed, by cutting rates a half-percentage point four weeks earlier than investors expected, broke its cardinal rule: don't surprise the financial markets. The rare action on 3 January produced more questions than answers about the Federal Reserve's plans for interacting with the economy and markets this year.
Fed Chairman Alan Greenspan and his colleagues signaled that they share Wall Street's fear that the economy is weakening too much.
The move succeeded in surprising markets and getting maximum mileage out of what's expected to be the first of a number of cuts. It also tossed an element of uncertainty into the Fed outlook.
By breaking with its tradition of measured and predictable rate changes, is the Fed adopting a more activist approach to rate policy? It is an important question for the bond market, which is at the front line of monetary policy moves.
Since 1994, the Greenspan Fed has gone to great lengths to telegraph moves to the market. It confined rate changes to scheduled meetings of the Federal Open Market Committee and simplified the language used to keep the markets abreast of where borrowing costs were heading.
It also moved slowly and in small doses, 25 basis points at a time, as it monitored how the economy and markets respond. It was a departure from the past, when the Fed - say, during the days of Fed Chairman Paul Volcker - often altered rates without a moment's notice by large amounts.
Realising uninformed markets could be more volatile ones, Greenspan and his colleagues decided to become clearer and more predictable. Later on, they even began releasing details about the likely direction of short-term rates right after FOMC meetings. Traders used to have to wait six weeks for that information.
Behind the changes was a desire to keep bond investors in the loop. After all, the fixed-income arena is the Fed's transmission mechanism and a better-informed and efficient market seemed in everyone's best interest. This week's surprise rate cut raised questions among investors about whether the Fed is adopting a less calculable relationship with the capital markets.
"I was surprised because it was sort of out of character for a Greenspan-led Fed,'' says Daniel Laufenberg, chief economist at American Express Financial Advisors in Minne.
It is doubtful the Fed will make a habit of shocking Wall Street, or moving in between FOMC meetings. Last year, the Fed said inter-meeting rate moves were useful "only in exceptional circumstances." In recent weeks, it seemed to find exactly that in signs of weakening sales, production, tightening conditions in the financial markets and indications that higher energy costs were sapping household and business purchasing power.
The central bank lowered its target for overnight bank lending rates half a percentage points to 6%. It also trimmed a quarter percentage point from the discount rate on loans to banks from the Fed system to 5.75%.
By citing further weakness of sales and production in the national economy, the central bank left open the door for another rate cut at its Jan 30-31 meeting. Already, the bond market has priced in another 25 basis points worth of easing later this month. the cut less effective in easing financial conditions and stabilising confidence, said Jan Hatzius, an economist with Goldman, Sachs & Co. in New York.
The same would have been true if policy makers held their fire until this month's FOMC meeting.
Of course, the Fed's timing had analysts wondering if the central bank had spotted trouble in the economy that the markets hadn't. In 1998, for example, the Fed picked up on turmoil in the capital markets and signs of a credit crunch before most investors. When it began cutting rates, markets took it as a sign of panic.
This time, the Fed is reacting to trends, including weakening consumer demand, rising inventories and sliding stocks, the bond market spotted long ago. It is unlikely the Fed is reacting to as-yet-undisclosed problems in the credit markets.
In fact, if Greenspan proved anything this week, it is that he can be taken at his word. A free-marketeer at heart, Greenspan often says that markets reflect the collective judgment of scores of knowledgeable investors, and that the Fed has no business contradicting them. True to form, Greenspan realised that the bond market got it right this time and chose to validate the drop in yields.
That didn't silence fears that the Fed's actions this week were aimed more at bailing out the sliding stock market than boosting the economy.
Some wondered whether the 74-year old Greenspan pushed for yesterday's move not so much to avoid recession as to protect his own reputation.
And others surmised that Greenspan was signaling to the new administration that it has things under control and that a big tax cut isn't necessary.
Yet all of this distracts us from the real issue: Whether Wall Street must brace for more shocks on the rate front. Although investors generally love a rate cut now and again, how might they respond to coming back from lunch only to find the FOMC has raised rates without warning?
There are no clear answers. At least one thing is for sure: suddenly, Fed watching has become interesting again.
William Pesek Jr. in the Bloomberg Washington newsroom
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