Though market players had resigned themselves to the conclusion that the Federal Reserve would not cut rates at Tuesday's policy meeting, they still held out hope. In the end, the Federal Open Market Committee voted unanimously to leave the federal funds rate target unchanged at 1.75 percent for the eighth straight month. Yet the Fed did throw market players a bone by returning to the easing bias they had favored until the mid-March meeting.

The Fed statement says:
"The softening in the growth of aggregate demand that emerged this spring has been prolonged in large measure by weakness in financial markets and heightened uncertainty related to problems in corporate reporting and governance.

"The current accommodative stance of monetary policy, coupled with still-robust underlying growth in productivity, should be sufficient to foster an improving business climate over time.

"Nonetheless, the Committee recognizes that, for the foreseeable future, against the background of its long run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness."

Bond market The initial reaction in the bond market was favorable. Treasury prices rallied because the statement raised the chances that the Fed's next move may be to reduce interest rates. Typically a shift towards an easing bias does signal that the Fed is more likely to reduce rates than leave them unchanged or raise them at a subsequent meeting. However, the easing bias does not make a rate cut a slam-dunk.

Former Fed governor Susan Phillips, interviewed on CNBC, said that the FOMC's decision was not pre-determined but made at the meeting. She said Fed governors and district bank presidents probably went into the meeting with particular convictions on the economy and views on how policy should be handled. But she stressed that no consensus had formed ahead of the meeting. Rather, committee members listened closely to the latest anecdotal reports brought by bank presidents from their respective regions.

This means that Fed officials don't necessarily have to predict what they will do at the next meeting. An easing bias means that risks are heightened towards economic weakness right now, but these could certainly change within the next month or two. By the next meeting (Sept. 24), economic conditions may look more favorable. A rate cut by the Fed is possible, but not assured.

Equity market The initial reaction in the equity market was negative. Stock prices were generally on the positive side of zero most of the day, but turned down moderately after the announcement. By the end of the day, declines were steep. It's difficult to say whether equity investors were simply disappointed that the Fed didn't lower rates or worried that the easing bias points to more economic trouble ahead. Keep in mind that lower rates are good news to equity investors for a short period of time, but these must be weighed against the weakness of the economy. If interest rates are falling because the economy is anemic, it also means that revenues and profits will be soggy. In the long run, equity investors would rather see solid corporate profit growth. Most of the time, a rising-rate environment is accompanied by strong economic growth.

Treasury markets shouldn't blame Fed for economy
Bond market players were insistent that the Fed should reduce the funds rate target. A handful of economists added fuel to the fire in recent weeks by changing forecasts and predicting that rate cuts would be imminent. But a Fed rate cut is only valuable if market rates follow suit and also decline. When the Fed started reducing rates in 2001, the yield on the 10-year Treasury note was about 5 percent. Twelve months later when the Fed had taken the funds rate down 475 basis points to 1.75 percent, the yield on the 10-year note was - about 5 percent. It did decline to as low as 4.20 percent but this was mainly related to September 11. The yield on the 10-year note hovered around 5 percent until mid-June when declines in equity prices became more pronounced.

The recent declines in yields have allowed mortgage rates to drift lower. Judging by the chart below, the spread between the 30-year mortgage rate and the 10-year note yield has been roughly unchanged over the past 18 months. Yet, the spread between the 10-year yield and the federal funds rate has only started to narrow in the past couple of months. Bond investors complain that the Fed hasn't done anything lately, but in fact Fed officials have left the federal funds rate target at a 40-year low during an early stage of recovery. Fed policy is unquestionably stimulative. The question is not why Fed officials aren't doing anything, but why Treasury yields aren't declining more steeply? Mortgage rates are tied to 10-year note yields. A drop in the 10-year yield will lead to larger declines in mortgage rates, in turn fueling further expansion in the housing market.

Other consumer rates
The financial incentives offered by automakers are well publicized. Consumers who buy the right cars and trucks and have good credit ratings are eligible for zero-percent financing (Not all models are eligible for zero rates.) But even consumers without the best credit are probably getting pretty decent rates on auto loans. The most recent figures show that auto-financing rates at auto financing companies averaged 6.29 percent in June. Commercial bank rates on auto loans have been less favorable, roughly 150 basis points higher.

Lower credit card rates would certainly spur consumer spending. Yet, credit card rates have barely budged. The average credit card rate was 13.55 percent in the second quarter, down 10 basis points from the first quarter of 2002 and down 134 basis points from the 2001 average. The 2001 average was down 82 basis points from 2000. Okay, let's do the math: the federal funds rate declined 475 basis points over the past two years but credit card rates are down 216 basis points, less than half. Bankers will tell you that credit card rates must incorporate high costs due to defaults on these unsecured loans. It is true that many credit card companies are offering special deals. These include zero interest for 6 to 12 months or reduced interest (near 5 or 6 percent depending on the issuer) for the life of the specific cash advance. These can help consumer spending in a limited way. For the most part, though, loan rates remain extraordinarily high.

BOTTOM LINE
Market players say the Fed should reduce rates further to help spur economic activity. Perhaps economic activity is not in the Fed's hands these days. The Fed has done its part to cut short-term interest rates. If yields on Treasury securities would also move lower, then mortgage rates would decline further and continue to fuel housing.

Perhaps market expectations have kept interest rates higher than they should be. The Treasury market pushed interest rates up in the first half of the year on inflated expectations of economic strength. Now market players worry about the weakness of economic growth in the second half of the year. Reduced expectations have allowed rates to drift lower. On Tuesday, Treasury yields fell sharply because the Fed's announcement was viewed as confirmation of economic weakness and a prelude to a near-term rate cut.

Credit card issuers might try reducing borrowing rates if they want to see consumer spending increase. The Fed did reduce the funds rate target quite drastically in 2001, but consumer rate declines didn't keep pace. The spread between the federal funds rate target and the consumer credit card rate has actually increased in 2002 rather than declined. A lot of consumers erroneously believe that bankers like to see a high interest rate environment. That's false. It is a lot easier to hide higher mark-ups amid low interest rates. In 2000, the difference between the federal funds rate target and credit card rates averaged 9.47 percentage points. In the first half of 2002, it averaged 11.9 percentage points. That is hardly the Fed's fault.

Evelina M. Tainer, Chief Economist, Econoday