To no one's surprise, the Federal Open Market Committee (FOMC) voted to leave its federal funds rate target unchanged at 1.75 percent and the bias set towards economic risk. But there was a twist! The vote was not unanimous. Fed governor Edward Gramlich and Dallas Fed bank president Robert McTeer were in favor of cutting the federal funds rate target Tuesday.

The federal funds rate target stands at 1.75 percent for the tenth straight month. One can see in the chart below that the Fed left rates unchanged for longer periods of time in the past ten years. For instance, the funds rate target stood at 3.0 percent for 17 months in the early stages of the recovery following the 1990-91 recession.

Tuesday's action raises the question whether the Fed will cut rates before the end of the year. Just leaving the economic weakness risk bias unchanged is no signal. But dissent, rare for the FOMC, suggests that perhaps other FOMC officials are also less than enthralled with the status quo. Traders in the futures market had already been convinced that the Nov. 6 FOMC would produce a 25 basis point cut. Tuesday's announcement has encouraged the suspicion that the Fed might actually do something sooner rather than later.

There is one problem with an inter-meeting rate cut: it suggests that the situation is dire. The soggy recovery is bad enough for the Fed, let alone a falling stock market. Consumers do spend more when they feel wealthier. Right now, consumers are not getting that wealthy feeling from the stock market. Granted, more consumers have a greater amount of their wealth tied up in real estate (their own home) rather than the stock market. But consumers can't feel good seeing lower and lower values on their quarterly 401(k) statements.

Treasury Market
Treasury yields did drop Tuesday after the rate cut. The chart below shows a downward trend in yields since March even as the federal funds rate target has remained unchanged. Some analysts ask why the Fed hasn't done more to spur economic activity. But the better question: Why did Treasury yields rise late last year and early this year at a time when the funds rate had settled at 1.75%. Bond investors believed that the economic recovery would be robust and that the Fed would soon begin raising rates. In fact, the economic recovery has turned out to be very anemic. The sluggish economic recovery changed market expectations and thus Treasury yields have come down. Interest rates are likely to remain low for at least a few more months. Even if economic conditions begin to improve, the Fed would not be likely to raise rates very quickly.

Mortgage Market
Mortgage rates have indeed declined to 40-year lows. However, the 30-year mortgage rate has declined much less than the federal funds rate target since the Fed first began to ease monetary policy. Housing starts have recently begun to decline in the past couple of months, but overall levels remain relatively strong and above 2001 levels. Should the 30-year mortgage rate drop further, it could bring in new homebuyers. At the very least, it would probably bring in a new round of refinancing activity, as the costs of refinancing would be offset by a significant reduction in the monthly mortgage payment even for recent homebuyers who have a 7 percent mortgage rate.

The chart below shows that the spread between the 30-year mortgage rate and the 10-year Treasury yield has increased significantly in the past couple of months. Whether or not home lenders are keeping rates high to boost profit margins, there is certainly a disconnect between these two rates. When the Fed began to ease monetary policy nearly two years ago, it counted on the near certainty that lower borrowing rates would spur consumer demand for interest-sensitive items and get the economy rolling. Indeed, the housing market has been soaring throughout this period - despite the fact (and maybe because of it) that a collapsing stock market has been eroding consumer wealth.

If the spread between the mortgage rate and the 10-year Treasury were to get back in sync, we should see a 30-to-50 basis point reduction in the mortgage rate from the current average of 6.12 percent (the first three weeks of September). If the 30-year mortgage rate were to approach 5.5 percent, there is no question that home sales and housing starts would pick up and a major new round of refinancing would begin.

Stock Market
With so much uncertainty in the economy and the financial markets, it's no wonder that stock prices are still on a downward trend. The bulk of the corporate malfeasance scandals are probably behind us, but investors remain concerned about financial statements and profit pronouncements. Can they be believed or not? No one knows for sure. In the meantime, President Bush continues to make war noises against Iraq while Defense Secretary Rumsfeld routinely updates the terror-alert color stream. It is hard to maintain a positive attitude against such news.

The stock market was already down when the Fed announced its decision on Tuesday, but the declines became more pronounced later in the day when the probability of a rate cut was enhanced. A rate cut is not a sign of economic strength by any stretch of the imagination. Equity investors want economic and corporate profit growth. A rate cut can only signal economic weakness. If the Fed decides to cut rates before the next meeting, it would signal very dire conditions to equity investors and would probably do more harm than good to the stock market.

BOTTOM LINE
Interest rates are at historical lows. The economic recovery, not helped by a declining stock market, is soggy but still moving forward. Many pundits would have the Fed cut the federal funds rate further and put more liquidity in the banking system. In fact, economic activity would increase if consumer rates would be more in line with the fed funds rate. Treasury yields have declined more dramatically in the past month, but mortgage rates have not come down in tandem. A drop in mortgage rates would help spur housing activity and residual markets. Banks have tended to reduce their prime rates when the Fed changed the fed funds rate target. In order to spur lending activity, any bank could reduce its prime rate from the current level of 4.75 percent. It's not as though they need the Fed's permission! Indeed, before the 1990s, the spread between the prime rate and the federal funds rate was well below 3 percentage points. Home equity loans are tied to the prime rate, as are many credit cards. A drop in the prime rate would help boost consumer spending.

Evelina M. Tainer, Chief Economist, Econoday