WASHINGTON -- The Federal Reserve lowered short-term interest rates yesterday and got a quick nod of approval from the bond market amid a growing conviction that inflation will not be much of a problem in a weak -- and possibly faltering -- U.S. economy.
The move followed renewed calls by the Bush administration for the Fed to abandon its neutral position on rates in the face of a sharp slowdown in the money supply, as well as calls by members of Congress to remove Fed anti-inflation "hawks" from their role in formulating policy.
Analysts said there was no doubt Fed officials were shifting policy on rates after the trading desk of the Federal Reserve Bank of New York added reserves to the banking system in open market operations. The action came when federal funds were trading at 5.75%, and market participants quickly concluded the Fed is now targeting a rate of 5.5%.
"This was an unambiguous signal," said John Williams, managing director of Bankers Trust Co. "In my mind, there's not doubt whatsoever."
The Fed added reserves by conducting overnight repurchase agreements, the most aggressive form of trading that is usually viewed as a protest against the prevailing federal funds rate. The Fed has other ways of adding cash to the banking system in its management of bank reserves that are considered less forceful and more ambiguous.
More rates cuts -- and possibly a reduction in the discount rate -- could be in store if the economy shows continued signs of ailing and Fed officials conclude more medicine is needed, said Neal Soss, chief economist for First Boston Corp. "One aspirin tablet is not a sustainable recovery."
The bond market was primed for a move by the Fed after the Labor Department reported on Friday that the job market in July deteriorated for the second month in a row. Although the department's household survey showed the unemployment rate fell to 6.8% from 7.0% in June because of a decrease in the labor force, a separate survey showed nonfarm payrolls fell by 51,000.
The market gave a ringing endorsement to the Fed's action, as yields on the Treasury long bond tumbled below 8.30%, the lowest levels since late May. The reduction in rates came just as dealers were preparing bids for the first leg of the Treasury's record quarterly auction of $38 billion in notes and bonds. Yields on $14.0 billion in three-year notes came in at 6.92%, the lowest level since February 1987.
The positive response in the market was in marked contrast to earlier this year, when investors feared that economic recovery would bring a rebound in inflation. Now, economists said, it is increasingly likely that any rebound will be so modest that price pressures wil not be a problem for some time. In that environment Fed policymakers have room to maneuver.
The Federal Open Market Committee, which sets monetary policy, is scheduled to meet Aug. 20.
"The inflation outlook is very favorable and is likely to continue to be favorable into next year as well" said Donald Fine, chief market analyst for Chase Securities Inc. "Any recovery that is incipient is going to be very, very anemic, and there are many people who are questioning whether we're going to have any recovery. It takes a long time for inflation to build, and it takes a long time for it to unwind."
Mr. Fine said he is looking for yields on long bonds to slip below 8% by the end of the year and continue moving lower next year as inflation in the service sector, manufacturing industries, and commodities remain in check.
Other analysts said it remains open for debate whether the U.S. recession is really over. Many expect that the Commerce Department's preliminary estimate showing an slight rise of 0.4% in U.S. output of goods and services in the second quarter will be revised to record a third negative quarter of growth.
"We had an uptick in the spring, but it doesn't look like it's lasting," said Marcos Jones, first vice president of Deutsche Bank Capital. Mr. Jones said he expects the Federal Reserve Board to lower the discount rate again from the current 5.5% to 5.0%. Such a move could probably pave the way for a reduction the bank prime lending rate, which is now 8.5%.
As recently as last Friday, President Bush repeated his call for lower interest rates to make sure the recovery does not falter, although Mr. Bush also reasserted his view that the economy will continue to expand.
However, Michael Boskin, chairman of the president's Council of Economic Advisers, has publicly complained at least three times that the money supply is not growing fast enough. He said this should prompt Fed officials to review their policy on rates. M2, a broad measure of the money supply, actually fell in July, and so far this year has grown by little more than 2.5% -- at the bottom of the Fed's official target range.
Members of Congress have also complained about the Fed's slowness in responding to economic weakness, despite the generally high regard for Chairman Alan Greenspan. Last week, Democratic leaders of the congressional Joint Economic Committee introduced legislation that would limit ratesetting to members of the Board of Governors, who are appointed by the President, subject to Senate confirmation.
The legislation would remove the district bank presidents from the Federal Open Market Committee. They are generally considered more prone to take a tougher stance on interest rates. However, analysts said, bank presidents also tend to place emphasis on the money supply, and the recent money figures gave Mr. Greenspan ammunition to persuade his colleagues to go along with another rate cut.