Federal Reserve move fails to spur markets

ANALYST'S VIEW

So much disappointment in so many quarters over something so expected. Go figure. The Federal Reserve ratified consensus expectations yesterday when it lowered both its benchmark overnight rate and discount rate by 25 basis points to 4.25 per cent and 4.75 per cent, respectively.

There was an instantaneous outpouring of disappointment. The stock market, TV commentators, economists, money managers and money markets were disappointed with the cut. And yours truly was disappointed at the wave of disappointment. The only people who weren't disappointed, but were surprised nonetheless, were bond investors who sent Treasuries soaring.

Almost all the 124 economists in a Bloomberg News survey had anticipated a quarter-point cut. The futures markets were on the same page.

Yet the Fed's execution of this deed sparked a huge sell-off in the stock market and a panoply of criticism from the peanut gallery.

How to explain the reaction?
"The market was looking for 'we feel your pain,''' said Jim Bianco, president of Bianco Research, an independent research firm in Chicago.

"They were expecting something else: something big on the discount rate, a special Y2K facility'' for those who can't borrow from the Fed.

Creative Solutions
Bianco said that press stories in the last two weeks had heightened expectations that "something else was coming,'' and the Fed would try to address elevated Libor rates.

Libor (London interbank offered rates), or the rate at which banks borrow from one another overseas, serves as a benchmark for many short-term loans, including adjustable-rate mortgages.

The Fed can pretty much place the overnight rate where it wants, and Libor generally follows. Not in recent months. The funds rate is 100 basis points lower than it was in September.

Yet the three-month Libor has fallen by only 25 basis points, reflecting a generalized unwillingness to lend. At 86 basis points, the spread between the two rates is the highest in seven years.

TV commentators said the Fed could have been more creative. They didn't say exactly what form that creativity would take. Brandeis University economics professor Steve Cecchetti, who admitted to being "a little disappointed,'' told Bloomberg TV the Fed should "try to figure out how to get the funds to the banks that need them the most.'' (Maybe ask them?)

No 'Visibility'
Earlier he had offered a concrete creative solution, suggesting the Fed extend the term of discount-rate loans from 30 days to 90. All in all, the sense was that the Fed should have done "something big.''

The 25/25 rate reductions didn't cut the mustard. The other disappointment, based on what I heard on TV, was the lack of "guidance.'' This came from an equity guy, who should know better. How can you provide guidance when there's no "visibility?''

Travel back to early 2001 when that other bubble was going bust and chief executives of technology companies talked about the lack of visibility.

It's not that they couldn't see clearly. It's that what they saw wasn't so hot. The Fed is now releasing three-year forecasts for economic growth, inflation and unemployment. Maybe investors wanted a little more clarity of what lurks around the next corner and less of a guess on how economic events will unfold in 2010.

Open-Door Policy
The Fed left the door open to further rate cuts, saying the central bank would "act as needed'' in light of the "deterioration in financial market conditions.''

That door is always open, even when it was closed at the conclusion of the last meeting on October 31 with a statement saying the risks to the economy were balanced.

Maybe all the disappointment was just a dose of reality creeping in.

Investors are looking for the magic bullet that would make everything OK, encourage banks to lend (a lower rate would help), heal the wounds in the home-loan market, wipe away the accumulated consumer debts and put the economy back on track.

Alas, there is no such tool in the Fed's arsenal. My two cents in the shoulda-woulda-coulda department is the Fed should have been more aggressive, getting ahead of the easing curve, and cut the funds rate by 50 basis points and the discount rate by 75 to narrow the spread and lessen the stigma (or increase the incentive of being stigmatized).

Policy makers "could have put an end to this recession discussion, which is a psychological thing right now,'' said Jim Glassman, senior US economist at JPMorgan Chase. Credit events tend to be a "slow grind,'' he said, unlike an old-fashioned inventory correction that is over when the shelves are bare.

The process is slow, painful and can affect all sectors of the economy.

Financial markets are anticipating more pain.

(The author is a Bloomberg News columnist)