December 11 rate action
The Fed reduced the federal funds rate target for the 11th time this year bringing the rate down 25 basis points to 1.75 percent. The FOMC also approved a request by a handful of Federal Reserve district banks to decrease the discount rate by 25 basis points to 1.25 percent. A minor debate is unfolding as to whether the Fed's statement accompanying the rate action signals further rate cuts or whether they believe the economy remains mired in recession. The statement indicated that signs of recovery were "preliminary and tentative". One could take that to mean that signs of recovery do indeed exist. On the other hand (economists always use both hands - and more), they could be discounting the signs of recovery as non-believable. They concluded that the risks were weighted mainly towards economic weakness. Some economists are predicting that the Fed has completed its easing cycle, whereas a few Wall Street economists are looking for one more rate cut on January 30, 2002.

Fed funds rate and the Treasury yield curve
Yields on Treasury securities can tell us a variety of things about the economy. A normal yield curve typically has short-term rates lower than long-term rates because investors must be compensated for their willingness to lend for a longer time period. This means that the yield on a 2-year note will usually be lower than the yield on a 10-year note or a 30-year bond. In comparison to December 2000, the first point on the chart below, the yield curve widened but was upward sloping with long rates (10-year note and 30-year bond) higher than short rates (2-year and 5-year notes). This is considered a normal yield curve.

During the month of November, bond investors came to the conclusion that an economic recovery was in the offing and that the Fed's easing cycle was complete. Consequently, rates jumped between 40 and 50 basis points across the spectrum of maturities. Another 40 to 45 basis points were added in the first week of December. The rate drop was exactly in line with expectations and not considered very newsworthy. But ever since the Fed began to include a statement with its announcement of rate actions following FOMC meetings, investors have been scrutinizing every word of the announcement. Bond market players interpreted the Fed's December 11 statement that the risks were weighted mainly towards economic weakness to mean that another rate cut was likely.

Even if the Fed has completed its easing cycle, most economists concur that the federal funds rate target will remain unchanged for a good chunk of next year. An economic recovery is expected to be moderate, and the unemployment rate will probably continue to rise long after the recession is over because it is a lagging indicator. Fed officials will be hard pressed to raise rates with a rising jobless rate.

As shown in the chart above, spreads between short and long term rates have widened considerably in the past few months. Not surprisingly, interest rates on Treasury securities rose from their lows posted immediately after the September 11 tragedy. However, it is possible that bond investors were over-exuberant in the sell-off of Treasury securities, which led to a sharp rise in their yields, when economic activity is in reality quite soggy.

Fed funds rate and the equity market
Stock prices fell on the eve of the FOMC meeting, not unusual behavior as investors try to not only divine what the Fed will do, but how they will phrase their post-meeting announcement, and how other investors will react to the news. The expected rate drop led to another decline in stock prices after the Fed announcement. Equity investors also seemed to feel that the wording of the Fed statement didn't reveal any conviction in the belief that the U.S. economy was on the verge of recovery. Stock investors are looking for signs of growth that will eventually lead to high profit margins - or indeed, any profit growth at all.

Conventional wisdom says that declining interest rates are bullish for the stock market. One would never know that by looking at the chart above. Actually, equity investors are interested in lower interest rates because they reduce borrowing costs. However, cash flow and corporate profits hold greater importance to investors, and they have been missing from the economic scene. Thus, declines in the major stock indices mirror the downward movement in the federal funds rate target - until September. Stock prices increased in October, not because interest rates fell, but because President Bush and Congress promised a fiscal policy stimulus package. The combination of the good news on the war front coupled with the promised fiscal spending led investors to believe that an economic recovery (with corporate profit relief) would commence in 2002. The economic growth that would stem from government spending and tax relief seems to be farther away now that the political game playing in Congress has returned in full swing.

In order to keep the rally going in the equity market, investors will have to see some credible signs of improvement in consumer or business spending and/or a fiscal stimulus package with some teeth that is passed before the 12th of never.

Federal funds rate and the economy
Consumers don't borrow at the federal funds rate, but bank prime rates are tied directly to the funds rate. As soon as the Fed announced a 25 basis point reduction, so did all the major banks. Prime rates now stand at 4.75 percent. Unfortunately, most consumers aren't able to borrow at the prime rate either. But home equity loans and many credit card loans are tied to the prime rate. Consumers with home equity loans are most likely to feel the benefit of the Fed's rate cut.

However, the relationship between credit card financing rates and the federal funds rate is more tenuous. The chart above compares credit card rates to the federal funds rate target over the past two years. Unfortunately, the credit card rate data is only available quarterly. Thus, we can't see if bank credit card rates came down further in the past couple of months. But even when the Fed had already reduced its federal funds rate target by 350 basis points, credit card rates came down a measly 139 basis points. Perhaps more recent data will show a more decisive drop in credit card rates since the third quarter. I certainly have been bombarded with applications from credit card companies offering zero percent interest on balance transfers or new purchases for a period of six to nine months. These offers might incite consumer spending in the same way that zero percent financing from automakers spurred motor vehicle sales. The relationship between the federal funds rate and auto loan rates is more marked than that with credit card rates.

One would expect mortgage rates to move in tandem with the federal funds rate, but mortgage rates are tied to Treasury yields. While we know that mortgage rates have come down in the past year, the decline is minor relative to the decline in the federal funds rate (475 basis points). Given that the 30-year mortgage rate actually increased in the first week of December relative to the November average, mortgage rates are only 54 basis points lower than a year ago. The problem, of course, lies with the fact that the mortgage rate is tied to the 10-year Treasury note. What can the Fed do? (Answer: nothing.)

Each and every month when housing starts or home sales are reported, we note that this sector is remarkably strong in the face of a significant recession in the manufacturing sector and the modest pace of income growth. Thus, the housing market has exhibited strength even without the corresponding drop in mortgage rates this past year. But herein lies a potential problem going forward. Usually, the transmission mechanism is such that the Fed will encourage economic growth by lowering interest rates; these will translate into lower mortgage rates. Consumers would buy new homes and furniture also boosting retail sales in the process. Given that we never saw a typical drop in housing activity during this recession, we may not see the normal surge during recovery either.

Many economists have been dismayed at how little impact the Fed's eleven rate cuts have had on the economy. If consumer interest rates are tied to market rates - such as Treasury yields - rather than the funds rate target itself, it is not difficult to see why the impact is so small.

Bottom Line
The Federal Reserve's decision to lower interest rates can impact the economy and financial markets together and separately. The Fed has a limited influence on short-term market rates, evidenced by the Treasury yield curve, but nearly none on long-term rates. If market rates don't move in tandem with the funds rate target, then the Fed's scope of influence is stymied because consumers won't benefit by lower borrowing rates. (Some will argue that consumers will be adversely affected because those who save by putting their money in bank CDs will find lower and lower deposit rates and receive less interest income to boot.)

The initial stock market reaction to Fed policy changes is based on investors' perception on how the economy will work with lower (or higher) interest rates. If consumer borrowing rates don't match up more closely with the federal funds rate, retail sales won't pick up, nor will corporate profits. Investors' expectations won't be met. A stock market rally can't continue indefinitely without a basis in reality, as we saw all too clearly in 2000-01.

Evelina M. Tainer, Chief Economist, Econoday