Tuesday's interest rate cut by the Federal Reserve, criticized by investors as too timid, probably reflects both compromise and a wary balancing of risks and potential reactions.
Financial markets quickly slumped in disappointment over the Fed's baby- step reduction in a key short-term rate, and the selloff, propelled by a 3% overnight slide in Japanese stocks, continued Wednesday. (See story on back page.)
But investors are so much on edge right now that they might have reacted similarly to a bigger cut-for different reasons, economists said.
"If the Fed had gone 50 basis points instead of 25, the markets might have worried it knew something they didn't," said Nicholas S. Perna, chief economist at Fleet Financial Group, Providence, R.I.
"I think the markets were very, very surprised last week by the hedge fund problem. And the Fed seemed to know of that in advance, since it orchestrated the rescue," he pointed out, referring to Long-Term Capital Management of Greenwich, Conn.
Though the quarter-point rate cut was modest, a larger move would have signaled that the banking and financial system required an immediate injection of liquidity.
"The markets expected a rate cut. Only the size was in question," said Sung Won Sohn, chief economist at Norwest Corp. of Minneapolis. "Since Chairman Greenspan's Fed has almost always moved in quarter-point steps, deviating from that pattern would have raised concerns."
At the same time, he said, stocks remain overvalued, and their predominant direction is downward, in the absence of some major positive surprise development.
The Fleet and Norwest economists also emphasized that the Fed no doubt wanted to preserve its future flexibility and control of the rate-easing process.
"The Fed needs to conserve its ammunition. I think there is much more turbulence to come. The global economic situation will probably get worse and last for quite some time," Mr. Sohn said.
"Maybe the Fed, right now, has in mind a total of 50 to 100 basis points of easing," Mr. Perna said. "If they had moved 50 basis points the very first time out, the market would have upped the ante, assuming 200 basis points. The Fed wouldn't want that."
Prospects of further Fed rate cuts were quickly factored into both the Treasury yield curve and the futures markets, he noted.
At the same time, the Fed was probably mindful of the impact of a rate cut on the dollar exchange rate internationally. "We could probably use a lower dollar right now to help exports-but we don't need a big decline right now," he said. "That would be difficult to deal with, generating forces that would raise rates."
If the market assumed a major easing and a related fall in the dollar's value, foreign investors might dump dollar-denominated holdings to avert depreciation. The resulting snowball effect would hurt the economy.
Finally, the quarter-point move in the federal funds rate-the wholesale loan rate at which commercial banks trade excess reserves among themselves on an overnight basis-may well have been a compromise within the Fed's Open Market Committee.
"There is still dissent within this group, and Greenspan has to deal with that," Mr. Perna said. "The Fed chair carries a lot of influence, but he's not a dictator. He has to have people on board, and they are not a bunch of pushovers."
