Fed Meets Today - Does Size Really Matter?

March 20, 2001 -- The Fed is going to slash interest rates today, but by how much is up in the air. There's a clear case to be made for the Fed to cut the, currently 5.5 percent, by 50 basis points, and a strong argument also to be made for cutting the funds rate by 75 basis points.

Nobody really knows what's going to happen. Right now, a total of 12 of 25 economists, as polled by Reuters, are betting that the Federal Reserve will ease policy by 50 basis points today

Even the fed funds futures contract betrays confusion. Odds, as measured by the April contract, already show 50 basis points in the bag, but it's also currently pricing in a 65 percent chance of a 75-basis-point cut. Such a move by the Fed, all at once, would be unprecedented.

The Case for 50

Those looking for a 50-point move had no trouble fashioning an argument for a 75-point move.

What makes a 50-point move most likely are recent measures of consumer spending. Automobile sales have rebounded recently and retail sales, on average, have also been stronger than the markets had originally anticipated. In addition, the University of Michigan's Index of Consumer Sentiment actually rebounded slightly in March, an indication that the average consumer is still spending money and still feels reasonably comfortable about job prospects (although confidence has clearly fallen sharply since last year).

"With a big drop in consumer sentiment [Fed boss Alan Greenspan would] have the cover to go 75 basis points," said Bill Quan, economist at Aubrey G. Lanston, who believes the Fed will cut 50 basis points. "All the economic data we've had says consumer demand has been relatively decent in the first quarter, showing modest growth."

These various reports, along with the Fed's own assessment of the economy, suggest that Fed officials would be wary of cutting by 75 basis points all at once if the only reason appears to be the equity market. While stocks' recent performance has been dreadful, the Fed has taken great efforts to suggest that the stock market only dictates Fed policy in how it affects the consumers' mind-set.

Greenspan explained his thinking about stocks at his Feb. 28 testimony, saying: "changes in stock market wealth have become a more important determinant of shifts in consumer spending relative to changes in current household income than was the case just five to seven years ago." He makes it clear that the recent consumer confidence figures are more important in suggesting the state of the consumer, rather than short-term moves in the stock market.

Those who believe the Fed will ease rates by 50 basis points also point out that the Fed could try to temper the market's reaction by suggesting in a strongly worded statement that the Fed might be ready to cut interest rates between this meeting and the next meeting, which is a long way off — May 15.

A 50-point cut is likely to disappoint the markets across the board, and the Fed generally does follow the market, but there's no guarantee that a 75-basis-point cut would satisfy the stock market (the Fed's 100 basis points of easing in January certainly hasn't done the trick for stocks).

"If they're still going to claim they don't target the stock market, a 75-basis-point cut makes any claim to that effect pretty laughable," said Ted Wieseman, economist at Morgan Stanley Dean Witter.

The Case for 75

However, it's not just the stock market that's looking for a 75-basis-point ease.

Two-year Treasury notes, which react to anticipated changes in Fed monetary policy, are currently yielding 4.29 percent — way lower than the current 5.5 percent funds rate — showing that the market is anticipating such a move. The April fed funds contract is pricing in a 65 percent chance that the fed funds rate hits 4.75 percent at the beginning of the month.

Considering the slim possibilities of an intermeeting cut, that's factoring in a decent change they go 75 today. And if the Fed is wary of looking like its policy actions are being unduly affected by the stock market, David Orr, chief capital markets economist at First Union in Charlotte, N.C., points out that the inventory correction, which Fed officials have sounded relatively optimistic about, is not proceeding quickly. Inventories rose more than expected in January despite strong consumer demand. Retail sales weakened in February, and haven't started off well in March, indicating an inventory correction may go on longer than the Fed expects.

"The premise was, the inventory correction was moving along decently and would be over by the summer, but the inventory numbers out last Wednesday showed retail inventories in January having risen 0.4 percent," said Orr. "That's not what would be happening if the inventory correction had been proceeding the way the Fed thought it was."

Meanwhile, corporate CEOs have all but busted down Greenspan's door and demanded, "What's all this crud about maybe not going 75 basis points?"

A multitude of corporate executives, concentrated in tech, have spoken of drastically reduced demand and are saying that demand may not even recover in the second half of the year, indicating more prolonged weakness in one of the economy's most dynamic sectors.

In addition, despite the freedom the Federal Reserve has in cutting rates anytime it likes, the FOMC still prefers to cut rates at regularly scheduled meetings. With anticipation of more economic weakness between now and then, the more prudent move might be to cut by 75 basis points at this meeting, rather than continuing on a path of incremental easing.

But whether an incremental path is the right course or not, don't look for a move back to Nasdaq 5000. That was last year's story.