NEW YORK (CNN/Money) - Many on Wall Street were surprised that the Federal Open Market Committee cut the fed funds target rate by just a quarter. It's hard to see why.
Yes, going into the meeting there were all sorts of good reasons for the Fed to drop the funds rate by a half point all the way down to 0.75 percent. The economy is in a fragile state, after all, and if the Fed really is worried about deflation, then cutting rates to the quick seems like a damn good idea. Heck, the Fed's own research suggests that it was partly the Bank of Japan's reticence over cutting rates hard and fast that put the Japanese economy into such a funk.
But where the half-point crowd got it wrong was forgetting that there can be a world of difference between what you think the Fed should do and what the Fed actually does. They didn't pick up on the fact that Fed has shifted tactics when it comes to rates, and that what it is most interested in now is devising ways to keep the rates on long-term debt, like Treasurys, bonds and mortgages, as low as possible.
The clue to all this came when the FOMC last met, on May 6. Although it didn't move on rates at that get-together, in its statement the Fed signaled that it was more worried about the prospect of deflation than inflation. That meant the Fed didn't plan on moving rates higher until well after the economy has recovered. With the risk of rising short term rates taken away, investors suddenly felt much more comfortable buying longer-term debt. And so long-term rates got driven down massively, spurring a huge spike in mortgage activity and corporate bond issuance -- just the stuff to help juice the economy.
Victory lap
Now, if the key to the drop in long-term rates was the market's belief that short term rates aren't going higher any time soon, how was the Fed going to keep that dynamic going? Not by cutting by a half point -- that would get the market thinking the Fed was done with cutting, and the next move would be a tightening. A quarter point cut, in contrast, would keep the market guessing that the Fed might cut another quarter later on. So a quarter point it was.
In its statement on Wednesday, the Fed sought to reinforce the notion that it is going to be keeping rates low by again noting that the risk of "an unwelcome substantial fall in inflation" exceeded the risk of a pickup in inflation, and then noting that it believes such deflationary concerns are going to "predominate for the foreseeable future."
So what's next? Most economists and bond market participants believe the Fed will be cutting again before the year is up, but this might not be the case. After all, the Fed might decide that holding out potential for another rate cut is a better way of keeping long-term rates down than actually cutting.
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