Today's Fed action
The FOMC announced a 25 basis point rate cut at the end of their two-day meeting today. This brought the federal funds rate target down to 3.75 percent and the discount rate down to 3.25 percent. In the past six months, the Fed has reduced the federal funds rate target by 275 basis points to its lowest level since May 1994. Along with the rate cut, the Fed issued a statement that indicated the economy was in dire straits. They cited declining profitability and business capital spending along with only weak consumer expansion as major problems. In addition, they feared that declining global conditions also weighed on the U.S. economy. Fed officials seem less concerned about inflation because "associated easing of pressures on labor and product markets are expected to keep inflation contained." The FOMC voted to maintain the easing bias ("the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.") While analysts were divided on the magnitude of today's rate cut, it is surprising that the Fed only reduced the funds rate target by 25 basis points because the accompanying statement made it sound like the economy was weakening more rapidly than it already had! We would have expected a more upbeat statement with the smaller rate cut today.

Fed Funds Rate and 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. However, as economic conditions change, the shape of the yield curve will also shift.

Investors often anticipate trends and it isn't unusual to see Treasury yields fall more rapidly than the federal funds rate that is governed by the Federal Reserve. In May last year, the Fed raised its target for the federal funds rate to 6.50 percent. Market players were already anticipating that the Fed would not only stop raising rates, but also eventually start to ease. The chart below shows that the fed funds target was stable between June and December, but Treasury yields fell - in some cases by more than one hundred basis points - even before the Fed decided to ease policy on January 3, 2001. Given that the Fed maintained its aggressive easing policy in the first half of the year, one would think that bond investors would react favorably and push yields down further. Indeed yields did fall on the 2-year and 5-year Treasury notes, but remained stable on the 10-year note and 30-year bond through the spring. By the time the Fed cut rates three times, yields on the longer term issues were already starting to inch up. Bond yields reflect economic conditions, but also reflect expectations of inflationary pressures. And bond investors were beginning to worry that inflation would flare up with the Fed's aggressive policy.