High on the list of reasons for encouragement about yesterday’s surprise 50 basis point cut in the federal funds rate: the size and timing of the move represent a rare acknowledgement of fallibility, and even error, by Fed Chairman Alan Greenspan. The urgency with which Greenspan engineered the cut was revealed by the unusual handling of the change in the largely symbolic discount rate, which is routinely kept in line with the funds rate and is normally no more than an afterthought in the process. As a formal matter, discount rate adjustments come under the auspices of the seven-member Washington Board of Governors, not the full FOMC, upon the request of the regional Federal Reserve Banks. In announcing its action yesterday, the Fed said the discount rate was cut by only 25 basis points, but added that the board “stands ready to approve a further reduction of 25 basis points … on the requests of Federal Reserve Banks.” In other words, the decision to cut the funds rate by 50 basis points was put through before a formal request for a like drop in the discount rate could be arranged. Such haste suggests Greenspan finally recognizes his error in not acting sooner to bring the overnight rate down from its extraordinary heights, and is prepared to sanction an uncharacteristically aggressive stance to heal the breach in economic confidence and protect his sterling reputation.

It also suggests, of course, that the wholly unjustified series of rate hikes that put up the funds rate from 4.75% to 6.5% will continue to exact a heavy toll from real economic activity until the Fed’s rollback is absorbed. A technical recession in the next few quarters certainly cannot be ruled out. As indicated by today’s equity market dip on the heels of yesterday’s remarkable 14% NASDAQ lightning-bolt rally, recovery for beaten-down, higher-risk financial assets will be no straight-line shot. At the same time, though, if market expectations of forthcoming Fed action prove to be correct, steady -- if at times uneven -- restoration of the market’s risk propensity is likely. At today’s close, fed funds futures are priced for another 75 bps in easing by the end of the first quarter, and a 5% funds rate by the end of June. As the market’s risk capacity has been sapped primarily by the 6.5% funds rate against a backdrop of nonexistent inflation expectations, such a decline of real short-term rates should prove highly salutary. A variety of instruments in higher-risk asset classes would seem to present tempting opportunities in this environment. Low-hanging fruit may be found among any number of high-yield debt issues of promising enterprises that essentially are now priced for default, for example, as well as scores of beaten and battered NASDAQ tech listings that now incorporate such soaring risk premia they have been reclassified from growth to value stocks. Don Luskin, CEO of MetaMarkets.com, has posted a list of these issues on his site.

Much as forward prospects can be said to have brightened at this point, the dollar price of gold  – at below $270 per ounce – has as yet indicated no relief from a deflationary scarcity of liquidity. No question, as we suggested last week, the Fed’s rate-targeting procedures can lead to perverse outcomes during periods of anticipated policy change (“A Deceptive Sense of Calm,” December 28, 2000). It appears, however, that the decision to open the easing cycle with a move that was unexpected in terms of its timing and size might alter these dynamics sufficiently to at least prevent further deflationary damage. During this morning’s intervention period, for example, reserve positions were considered ample and the New York open market desk was generally expected to remain out of the market. But with funds trading slightly above the new 6% target, the desk executed a repurchase agreement of $2 billion for 28 days. The best chance for some reflationary impulse in the unit of account, however, will probably come more on the liquidity demand than supply side, as falling short-term rates should eventually offer a less compelling real return to holdings of risk-free cash assets.  

In addition, the Fed’s rate cut yesterday, and the anticipation of significantly more to come, has led to a normal yield curve distribution – with no part of the bond curve inverted relative to shorter-term issues – for the first time in nearly a year. This would suggest a significant part of the deflation trade driving longer-term yields below shorter-term ones has been unwound, a fact that seems to have been affirmed by yesterday’s sell-off of the 30-year Treasury, with its yield rising from 5.35% to 5.5%. We recently noted that confirmation of Fed action would likely lead to a pause in the bond rally (“Another Rout On Wall Street,” December 20, 2000). There remain, however, few indications of downside risk to Treasuries, with a somewhat longer-term upside keyed ultimately to the extent of the Fed’s rate-cutting exercise.