To no one's surprise, the Federal Reserve left the federal funds rate target unchanged at 1.75 percent after their 2-day meeting this week. The statement accompanying their announcement said: "Signs that weakness in demand is abating and economic activity is beginning to firm have become more prevalent." This was in contrast to the previous month when they noted that signs of improvement were "preliminary and tentative". But the Fed also noted that business capital and household spending decisions were still uncertain. Consequently, the Fed maintained their easing bias and noted that the "risks are weighted mainly towards conditions that may generate economic weakness in the foreseeable future."

Treasury market reading
Treasury prices fell and yields rose on Wednesday after the Fed's announcement. While bond investors were encouraged by the fact that the Fed maintained the easing bias, they were disappointed that the Fed saw somewhat more entrenched signs of economic activity than at the previous meeting. Bond investors have somewhat of a zero-one personality. That is, either the Fed will ease or the Fed will tighten. In fact, the Fed can do nothing. During the last recession, the Fed had not completed easing until well into the recovery. The Fed's last move (to lower the fed funds rate target to 3 percent) was on September 4, 1992, more than one full year after the economic recovery had already started. The Fed maintained no change in policy until February 1994.

Bond investors will claim that times are different. Indeed every recession and recovery has its own special factors and foibles. But it also means that a rate hike is not imminent. The strength of the economy coupled with the prospect for inflationary pressures would determine how quickly the Fed would need to act in order to prevent overheating. At this point, Greenspan & Company generally believe that market players have overestimated the strength of the recovery for 2002.

It is true that real GDP inched up at a 0.2 percent rate in the fourth quarter. But these data are preliminary and boosted by a surge in auto sales, which in turn, were boosted by zero percent financing incentives. Inventory liquidation was strong, and does set the stage for recovery in coming months, but business demand continued to decline. It limits the kind of production gains we will see going forward.

The chart below depicts the Treasury yield curve relative to the federal funds rate target. The Fed was aggressive in its easing policy over the past twelve months, but the chart below shows that Treasury yields didn't decline in tandem with the fed funds rate target. If the Treasury market continues to remain optimistic about the degree of economic growth and yields rise commensurately, they'll see that the intended recovery is muted by the very fact that interest rates are rising. Typically, interest sensitive sectors lead the economy out of recession and towards recovery and expansion. Housing was strong during the recession; there is no pent up demand for a strong recovery. Auto sales were boosted by special financing rates; the pent up demand for autos may be limited as well. So what do bond investors see that will create a strong recovery?

Equity market reading
Stock prices have been troubled by earnings and accounting problems in the past week. Equity investors were generally buoyant until the beginning of the year when they became concerned that they had been overly optimistic about the outlook for corporate profits in the near term.

Equity investors were heartened by the Fed's announcement that signs of economic activity were beginning to firm. Typically, equity investors are as pleased as bond investors to see interest rate declines, but revenue streams govern stock prices. Economic growth is generally accompanied by gains in corporate profits, so equity investors would prefer signs of growth. The stock market's reaction to the Fed announcement was initially muted, but by the closing bell, the Dow was up 145 points and the Nasdaq composite index was 20 points higher.

While the Fed's reading of the economy was generally friendly news for stock investors, equity markets may still see some rough waters ahead as investors remain jittery about earnings statements and mis-statements. Whoever thought accounting procedures would create such excitement?

Bottom Line
Bond investors were disheartened by the Fed's view that the economy was showing signs of life because they think it means that the Fed will soon start raising rates. In reality, the Fed remains concerned about the strength of the economic recovery. History has shown that the Fed doesn't begin to tighten credit conditions on Day One of a recovery.

Equity investors were pleased that the Fed saw signs of life in the economy, but the stock market is beset by other minor problems, such as accounting statements and current earnings news. Economic growth will eventually lead to corporate profits gains, but choppy waters may keep investors on tenterhooks in months ahead.

Evelina M. Tainer, Chief Economist, Econoday