Investors expect the Federal Reserve to cut interest rates again Tuesday, but the two rate cuts so far this fall have not removed the uncertainty surrounding the central bank's next move.
The view is clouded for at least three reasons. First, the Fed, in the postwar era, would typically be raising instead of reducing rates in this part of the business cycle.
Second, the Fed departed from its Greenspan-era routine a month ago and cut rates between policy meetings to calm the financial markets. Third, however, the enormous jump in stock prices that came after the Fed's moves may have complicated matters.
"Having broken out of their old modus operandi, the Fed leaves pure conjecture about what it will do next," said Robert A. Brusca, chief economist at Nikko Securities Co. in New York. "There is no historical record to draw on, so we are all feeling our way around in the dark."
"With more than the normal amount of uncertainty hanging over the markets, we should not be surprised if an increase in volatility results," he added.
"The markets are psychotic," asserted Edward Yardeni, chief economist at Deutsche Bank Securities in New York. "Manic depression is my diagnosis.
"Stock markets around the world were very depressed from mid-July through mid-October. Over the same period, government bonds were manic. But there has since been an amazing reversal."
Investors appear convinced, he said, that the central banks "will keep the bull market alive and that there is no downside risk." In fact, they appear to have decided they will again be rewarded for "buying on the dip."
As a result, the relief rally in stocks sparked by the Fed action has turned into a buying mania, indeed, a "buying panic," Mr. Yardeni said. Meanwhile, government bond yields, which plunged in the flight to quality before the Fed acted, have since risen significantly. "I still expect a quarter-point cut" at the Tuesday meeting, "but I am losing confidence in this forecast," the economist said.
"Fed Chairman Alan Greenspan has to be concerned that his Oct. 15 rate cut may have revived irrational exuberance in the stock market much more than it reduced excessive risk aversion in the credit markets," he said. Many nongovernment spreads in the credit markets remain near recession levels.
If rates are cut again, "the Dow Jones industrial average could soar into record territory, and the government (30-year) bond yield could approach 6%," he said. "This is not a scenario that would be welcomed by the Fed."
Mr. Brusca said the most uncomfortable Fed official right now may be William Poole, president of the Federal Reserve Bank of St. Louis and a champion of the monetarist approach to central banking.
Until a few months ago, Mr. Poole apparently still favored a rate hike by the policymaking Federal Open Market Committee. Shortly after the Oct. 15 rate cut, he emphasized in a speech that the Fed objective should remain "zero inflation."
But economic strategist L. Douglas Lee of HSBC Securities said the Fed is probably also concerned about an adverse market reaction if it does not ease further. "We do not believe the Fed would be pleased by more market volatility."