Bond Market Is Giving the Fed the Go-Ahead For Another Ease on Signs of Weak Economy

WASHINGTON -- The bond market is giving the Federal Reserve the nod to go ahead and lower short-term interest rates another notch amid fresh evidence of a listless economy.

Analysts say the market is priced at least partially for another easing in policy by members of the Federal Open Market Committee, which is set to meet today. Two-year notes, which generally reflect expectations about Fed policy, are down to 6% -- only 75 basis points from the current federal funds rate of 5.25%.

Analysts say a reduction in the federal funds rate from 5.25% to 5% is likely in the next several weeks. "We think that in the month of October we're likely to see another easing," said Richard Berner, director of bond market research for Salomon Brothers Inc. "The FOMC is merely just another milestone along that path."

The key economic indicator will be the Labor Department's unemployment report for September, due out Friday. Economists expect a small rise in nonfarm payroll employment and an increase in the jobless rate from 6.8% to 6.9%. Any increase in payrolls under 40,000 would probably be viewed as weak, according to Kathleen Stephansen, vice president for Donaldson, Lufkin & Jenrette Securities Corp.

Inflation, the normal goblin for Fed officials, is hardly in sight.

The market perception of economic weakness combined with low inflation has brought the yield on 30-year Treasury bonds down to 7.80%, a four-year low. Other types of rates are also down dramatically. The average fixed-rate mortgage has fallen to 8.92%, a 14-year low, and the prime lending rate at banks has dropped to 8%, the lowest since 1987.

Normally, lower rates need time to work their way into the economy and influence decisions by consumers and businesses to spend and borrow. That process typically takes from six to nine months and would argue for a pause in Fed policy changes so that officials can gauge the impact of recent rate cuts, including the Sept. 13 lowering of the discount rate to 5.0%.

Still, say analysts at Merrill Lynch in their latest market letter, "discouragingly slow money supply and credit growth suggest that another easing will be needed to do the trick. . . The bond market is giving the Fed another go-ahead."

Treasury Secretary Nicholas Brady picked up the administration's theme that the credit crunch at commercial banks is the biggest impediment to a sound recovery.

"The essential fact is that banks are not performing their traditional function as ~shock absorbers,' lending to businesses and individuals to help pull them through the tough times," Mr. Brady said in a speech yesterday in Atlanta.

The Treasury secretary and other members of the cabinet-level Economic Policy Council met with President Bush on Friday to review the credit crunch. The meeting included Federal Reserve Board Chairman Alan Greenspan, although he is not a member of the council.

Officially, administration officials are saying that the problem with the credit crunch lies with recalcitrant banks reacting to overzealous federal bank examiners -- not interest rates. Mr. Brady noted that the federal funds is down some 300 basis points since the summer of 1990, while the discount rate of 5.0% is the lowest since 1973.

But the administration also is concerned about slow growth in the money supply, which it argues is essential to economic growth.

The money supply can be boosted by lower rates, and the lag of months required for rate changes to work their way fully into the economy is not promising for an administration facing an election a little over a year from now.

Meanwhile, some analysts are questioning the sustainability of the recovery, which public opinion polls show many people believe to be not a recovery at all but a continuing recession. "Who is out of touch with reality here, consumers or economists?" writes Robert Brusca, chief economist for Nikko Securities Co. International, in his latest market letter.

There is clear evidence of a broad and vigorous rebound in the manufacturing sector, but not in the whole economy, says Mr. Brusca.

Analysts at Donaldson, Lufkin & Jenrette Securities Corp. estimate that real gross national product in the third quarter rose only about 1%, largely because of continued weakness in the trade sector and inventory drawdowns by business. "With money growth down and weakness in the economy, it's very difficult to make a case for a revival of inflation," said Ms. Stephansen.

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