The Federal Reserve has left financial markets dangling, for the moment.
Each day for the last two weeks, the markets have expected the central bank to cut its 9 1/2 percent discount rate -- the interest it charges on loans to financial institutions -- as part of an effort to get an economic recovery going. Each day the markets have been disappointed, and each day they get more and more nervous at the Fed's failure to move.
The markets are nervous because both stock and bond prices have risen in anticipation of additional cuts in the discount rate. Treasury bills, high-grade commercial paper and certificates of deposit issued by money center banks all are carrying interest rates lower than the Fed's discount rate. And rates for long-term bonds have continued to fall.
Meanwhile, the federal funds rate -- the interest rate at which financial institutions lend funds to each other -- has averaged 9 1/2 percent over the last four weeks, exactly the same as the discount rate. Normally, the Fed's operating procedures assume the federal funds rate will be somewhat higher than the discount rate because that spread allows the Fed to maintain the degree of tightness it chooses in the banking system.
"These developments suggest that the markets expect additional monetary accommodation in order to maintain these rates and even to encourage further declines in the weeks ahead," declared Henry Kaufman, the influential Salomon Brothers economist.
If the Fed does not provide that accommodation by lowering the discount rate, the stock and bond rallies could be choked off as other interest rates rise sufficiently to reestablish normal relationships with the discount rate. That could delay the expected economic recovery, analysts warn.
Many of the usual interest rate relationships have shifted as a result of the Fed's announcement early last month that it would temporarily disregard the level of M1, the measure of the money supply that includes currency in circulation and checking deposits at financial institutions, as a guide for setting monetary policy.
That announcement, interpreted by many financial analysts as a signal that the Fed would push down interest rates finally to spark a recovery, at least set off a rally in both the stock and bond markets.
Federal Reserve Chairman Paul A. Volcker cautioned that the Fed has not abandoned use of the broader monetary aggregates as guides to policy, and that it certainly has not dropped its longer-term goal of reducing inflation by slowing growth of the money supply. But in the short run, M1 would be distorted by a number of technical factors and therefore could not be used, he said.
With M1 well above its target range, the markets took the Fed action as an indication that it was intent on getting the economy moving again and would push interest rates downward until that happened. The present relation among various short-term interest rates shows that that expectation has not changed.
Most observers expect the Fed shortly to cut the discount rate, probably to 9 percent, with other cuts possibly to follow, precisely because of the economy's weakness.