The Federal Reserve is being pushed into a tight corner. Just as the pressure grows for quicker and bigger interest rate cuts, Fed officials are trying to wean investors and traders away from their belief that the Fed will rescue them from losses.
Wednesday, as the Dow Jones industrial average fell as low as 9,817.74, some analysts and strategists were talking about the Fed's doing more when its policy committee meets on Tuesday.
"I think the Fed is clearly going to have to take the more aggressive posture here," said Thomas M. Galvin, chief investment officer at Credit Suisse First Boston. "I think this is probably going to force their hands to provide bigger changes sooner."
Galvin now expects a cut in the benchmark federal funds rate of three-quarters of a percentage point — more than the half-point reduction he foresaw earlier.
The expectation of a larger cut was reflected Wednesday in the sharply declining yield on the Treasury's two-year note. The yield plunged to 4.29 percent from 4.44 percent on Tuesday, its lowest level since the fall of 1998. Futures contracts on federal funds also moved in that direction.
But the Fed's reluctance even to appear as if it was responding to a falling stock market — besides broad economic conditions like unemployment, inflation and the pace of growth — could leave investors disappointed.
"They have labored to wean the market from the perception that they are out there supporting markets," said Richard Berner, chief U.S. economist at Morgan Stanley Dean Witter. "If the Fed is perceived to be supporting markets, investors will take more risks than they should."
In some ways, the problem is of the Fed's making because, in recent times, it has brought a relatively quick end to market plunges. In 1987, when Alan Greenspan was the new chairman of the Federal Reserve, the bank cut interest rates immediately after the October crash. In the Russian financial crisis in the summer of 1998, the Fed gave the market three quick quarter-point rate cuts as stocks were falling and bond markets seized up.
Right after the first trading day of this year, when the Nasdaq composite index plunged 7.2 percent, the Fed announced a surprise half-percent reduction between meetings. At the end of the month, policy-makers followed with another half-point cut at their regular meeting.
The impact of these rescues can be heard in an odd Wall Street refrain these days: The economy is not slowing enough. Not slowing enough? As if that were good for stocks.
But in the odd way that many investors look at the world, they seem to want an economy in enough trouble to force the Fed to make deeper and quicker interest rate cuts.
Take last Friday, for example. The government announced that 135,000 new jobs had been created in February, more than expected. That was good news because the economy might not be slowing so sharply and perhaps that would help slow the decline in corporate earnings.
But to many investors, this meant that the Fed might go slower on future rate cuts. And that conclusion played a role as stocks fell on Friday, and again Monday and Wednesday. "That is convoluted thinking," said Alfred Goldman, chief market strategist at A.G. Edwards in St. Louis. "But I think there is a distorted hope that the Fed can make things better immediately."
The reasoning would seem simple. Investors think that rate cuts are the quickest and surest way to ensure that the economic slowdown will reverse and, therefore, make it safe to pile into stocks again.
Robert J. Barbera, chief economist at Hoenig & Co., said money managers he talks with say they already know that business is bad for the companies they own. "So the only hope they get from the macroeconomic data is that the economy stinks enough so that they will get a big dose of interest rate relief."
That is why it is hard to keep investors away from their favorite tonic. But if the Fed slows the doses, that could slow the recovery of the stock market until the Fed moves much further into this rate-cut cycle.
This is not to say that policy-makers do not worry about the stock market. Stocks can have a major impact on the economy through what is known as the wealth effect. As the value of people's investments rise, they feel richer and are likely to increase their spending. And when the market falls, the reverse can occur. So a continued decline now could curtail spending and make the economy much weaker — a danger the Fed chairman, Alan Greenspan, has acknowledged.
But he has also tried to make clear that the Fed is not focusing directly on the stock market and letting it lead policy decisions.
When the Fed was raising rates in 1999 and in 2000, Greenspan said it was responding to how stocks affected the economy. And at the end of last month, before a House committee, Greenspan said it was too early to tell if the stock market was sufficiently affecting the economy to cause a recession.
"In fact, as an old colleague of mine once said, 'The stock market forecasted five of the last two recessions,"' he remarked then. "And so we have to be careful about being fairly strict in analyzing what stock prices and equity values are doing and what is happening to demand."
Whether the market, through the wealth effect, is "enough to actually induce a significant contraction which in retrospect we'll call a recession, is yet too early to make a judgment on," he said.
He added that policy-makers preferred to make their interest-rate decisions at regular meetings, not in between.
Before the market fell further this week, there were even some analysts suggesting that Fed policy-makers might cut the benchmark short-term interest rate just a quarter of a percentage point, to 5.25 percent. Given that there are some signs the economy may not be as weak as thought, such a move would emphasize the Fed's distance from the stock market.
But with plunging stocks now, many analysts are emphasizing what they forecast weeks ago — a half-percentage-point cut in the federal funds rate, the rate on overnight loans between banks. What is less likely, assuming the Fed keeps its distance from the stock market, is the three-quarters-of-a-point rate cut now being talked about on Wall Street.
This does not mean that things will not change. This is because with this week's sharp fall in stock prices, another ingredient has been added to the Fed's mix. That is the financial and political trouble in Japan, where the Nikkei index of 225 stocks has fallen to its lowest level in 16 years.
If things worsen in Japan, with the world's second-largest economy, then the outlook could worsen globally, and that could change the Fed's thinking, regardless of what happens in the stock market here.