WASHINGTON -- Bond market participants are wondering whether the Federal Reserve's cuts Friday in short-term interest rates signal the end of the recent market rally.

For the municipal market, the Fed's cut in the discount rate to 5.0% from 5.5%, and an accompanying action to lower the federal funds rate to 5.25% from 5.5%, carry a mixed message, said George Friedlander, a managing director of Smith Barney, Harris Upham & Co.

Except for refundings, the volume side of the market is not that sensitive to rate changes. Still, he added, "if Treasury rates continue to decline, long-term municipal rates will continue to decline," which would be good news for state and local issuers that come to market.

On the demand side, Mr. Friedlander said he sees the market "holding up very well." The decline in short-term rates gives an incentive for potential issuers to get active, and investors who have been getting out of certificates of deposit and money-market funds have a greater interest in long-term municipal bond funds.

The Federal Reserve Board signaled its shift to an easier monetary policy in a 4-to-0 vote to slash the discount rate, marking the lowest rate since 1987. Federal Reserve Board Governor Edward Kelley was on vacation but supported the decision, a Fed spokesman said.

In explaining the move, the Fed cited weakness in the supply of money and credit, "the improving inflation environment," and "concerns about the ongoing strength of the economic expansion."

Fed officials announced their move shortly after 9 a.m. following a report from the Commerce Department that said retail sales in August tumbled 0.7%. It was the biggest monthly drop since January, led by a large decline in automobiles and other durable goods. But sales of nondurable goods also were weak, with declines at department stores, clothing stores, and food stores, the report showed.

Money supply barely has been growing at all. M2, the broad measure of money that gets the most attention by Fed officials and the bond market, tumbled $9.7 billion in the latest reporting week and has, in general, been at the bottom of the Fed's targeted growth range of 2.5% to 6.5%.

The Fed also acted after the Labor Department reported that the consumer price index in August rose a modest 0.2% for the third consecutive month. In the last year, consumer prices were up a reassuring 3.8%.

The bond market was expecting the Fed to cut the discount rate, and it also was not surprised when the trading desk of the Federal Reserve Bank of New York added $3 billion in reserves to the banking system in open market operations, an action that was widely seen as ratifying a cut in the federal funds rate.

Major commercial banks followed up on the Fed's actions by lowering the prime lending rate to 8.0% from 8.5%. Normally, a cut in the prime rate translates into lower borrowing costs for home-equity loans and some other types of loans. Mortgage rates have already been edging lower since the middle of the summer. The Federal Home Loan Mortgage Corp. on Friday announced that the average fixed mortgage rate was down to 9.02%, the lowest since January 1978.

But a number of economists say that the Fed will have to lower rates further to nudge along a soft economy that shows few inflationary pressures. The recovery, these analysts say, is anemic by historical standards, and the bond market still can achieve further gains.

Statistically, economists expect third-quarter gross national product to show an increase of around 3%, largely on a slower pace of inventory liquidation by business and a pickup in consumption during June and early July.

But there is also evidence that the consumer sector, which is crucial to powering sustained economic growth, is faltering. "Autos and housing do not seem to be showing any signs of a rebound, and that's got to be troubling for the Fed," said Stephen Slifer, senior vice president for Lehman Brothers. "Interest rates are still too high."

Mr. Slifer sees long bonds falling to 7.25% as consumers and businesses continue to pay off their bills from the consumption and credit boom of the 1980s. The yield on the 30-year Treasury bond closed Friday near 7.95%, capping a week-long rally.

"It's become clear that at best we're going to get a weak recovery, and there's a lot less anxiety about inflation," said Laurence H. Meyer, president of Laurence H. Meyer & Associates Inc. in St. Louis. The firm is forecasting that long-bond rates by the fourth quarter of next year will be down to 7.5% and Treasury bill rates down to 5.4%.

Joseph Waheb, chief economist for Wells Fargo Bank in San Francisco, is even more bullish. He forecasts the long bond will hit 7.5% by November.

"The odds still favor lower interest rates, especially at the longer end of the yield curve with maturities of five years or more," said Samuel Kahan, chief economist for Fuji Securities Inc. in Chicago.

Other analysts are less optimistic about the future course of bonds. "Any signs of a revival in the tempo of business activity is likely to be viewed as a worrisome sigh by investors," said William Sullivan, director of money market research for Dean Witter Reynolds Inc. "The bond market should be concerned about growth, and if we see a rebound, rates could be under some upward pressure."

Mr.Sullivan said he is troubled by the Federal Reserve Board's reference to "an improving inflation environment" in its announcement of the discount rate cut. The core rate of inflation, excluding food and energy, has been advancing at a rate of 0.4% in the last few months, and that translates into an annualized rate of close to 5%, he said.

"I would think the Fed will go into a fairly long period of neutrality to see if these rate cuts sparks a rebound," said Joseph Liro, senior vice president for S.G. Warburg & Co. "There's a good chance the Fed won't have to ease any further, and I think there'll be a lot of resistance to further declines in rates."

International investors can buy German 10-year bonds yielding 8.40% compared to about 7.61% on 10-year U.S. bonds, said Mr. Liro. "Rates will be higher going into next year than they are now. We've been advising clients to use the latest rate decline to lighten their positions."

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