Business Outlook: U.S. ECONOMY
THERE MAY BE A RATE CUT UNDER THE TREE
Christmas is in the air, but will the Federal Reserve be in a gift-giving mood when its policy committee meets on Dec. 19?
Until recently, the betting was that the Fed wouldn't cut interest rates until the budget squabble is over and a deficit-cutting deal is in hand. But amid new signs of softness in the economy--and persistently good news on inflation--a rate cut may be shaping up on economic grounds alone, even if Congress and the White House remain at loggerheads.
Top Fed officials now concede that the economy has taken on a softer tone in the fourth quarter, led by an inventory adjustment that is taking longer than expected. They also believe that technological change and its impact on job insecurity is, at least for now, limiting upward wage pressure.
The same policymakers also assert that the Fed responds only to the economy and the financial markets, suggesting that a budget deal is not necessarily a prerequisite for an interest-rate cut. Vice-Chairman Alan S. Blinder has been especially outspoken in his support for an easing in policy, but he also says that a monetary-fiscal quid pro quo is not proper Fed policy.
What the central bankers will pay particularly close attention to are weak-looking retail sales, the malaise in manufacturing, and signs that housing is retracing some of its earlier gains despite low mortgage rates. Reports from a broad range of economic players all look paler, and the composite index of 11 leading indicators dropped 0.5% in October (chart). While these signals aren't flashing recession-red, they do at least shine caution yellow.
INDEED, WHEN THE COMMERCE DEPT. unveils its new chain-weighted measure of gross domestic product, also on Dec. 19, the economy's yearly growth rate for 1995 could shift downward as much as a full percentage point compared with the current 3% pace.
The new measure, which will replace the present constant 1987-dollar readings, is likely to peg third-quarter GDP growth in excess of 3%. But by all indications so far, the fourth-quarter pace is shaping up to be well below that. The new numbers will suggest more slack in the economy and also more room for the Fed to cut rates.
The economy's more somber pace was evident in the Fed's own assessment of regional activity prepared for the upcoming meeting. The Dec. 6 report, known as the beige book, said national economic activity continues to expand, "but at the somewhat slower pace reported in the last beige book."
The report characterized early holiday sales as mixed, but it did point to strength in construction, as evident in the Commerce Dept.'s October report on construction spending (chart). Outlays jumped 2.7%, the largest increase in 3 1/2 years, led by a surge in public construction.
The Fed survey also reported that labor shortages in some areas were lifting wages, a point that gave the bond market pause after the report's release. However, the roundup also noted widespread reports of retail price discounting and that inflation remained in check.
THE BOND MARKET seems increasingly convinced that a softer economy and an eventual budget deal will lead to less inflation potential and lower interest rates. The yield on the benchmark 30-year Treasury bond briefly slipped below 6% on Dec. 4 for the first time in two years, and on Dec. 6, the yield dipped as low as 5.96% before the beige book came out, sending it back to 6.04% at the close. The strength in bonds is helping to fuel the surge in stock prices.
The past year's drop in bond yields of more than two percentage points has occurred with just a single quarter-point cut in the overnight federal funds rate by the Fed on July 6. This decline has managed to produce the flattest yield curve in years, with only a half-point of difference between the rates on the three-month Treasury bill and the 30-year bond.
A more normal, upward-sloping curve seems most likely to be restored with an adjustment at the short end. The fall in long-term yields in the face of little movement in short-term rates suggests an outright reduction in inflationary expectations. That alone would be grounds for the Fed to justify a further easing of short rates.
Of course, with the bond market already expecting up to a half-point of Fed easing, along with a credible deficit-cutting budget deal, the danger is a backup in rates if these events fail to materialize at a time when the economy is looking less hardy.
In particular, after-Thanksgiving retail sales still look weak by nearly all readings, including those from Telecheck Services, the International Council of Shopping Centers, and Mitsubishi Bank/Wertheim-Schroder. The widely followed survey by Johnson Redbook Service showed that sales at department and chain stores fell 1.6% for the week ending Dec. 2, getting the month off to a poor start.
At the same time, the factory sector remains listless, with growing evidence that further inventory adjustment is restraining output and employment. Durable goods orders dipped 1% in October, although they had risen in both August and September. And first-time jobless claims are trending higher.
FACTORY SLUGGISHNESS continued in November, says the National Association of Purchasing Management. The NAPM's index of industrial activity slipped further in the month, to 46.5% from 46.8% in October. A reading below 50% implies that activity--measured by a composite of orders, output, employment, inventories, and delivery times--is weakening. The index has been below that mark for four consecutive months.
The NAPM's index of delivery times is one of the many indicators known to strike the fancy of Fed Chairman Alan Greenspan. In November, an increasing percentage of vendors reported faster deliveries. That's a sign of increasing market slack and thus of waning price pressures (chart).
Indeed, the NAPM's price index showed that the prices paid by companies for materials and supplies fell for the fourth consecutive month, and the purchasers reported little success in passing along price hikes that had occurred earlier in the year.
Greenspan also has taken note of a special question put to the purchasers about inventories. The survey shows that a sizable 49% of the respondents characterized inventories of final goods as being too high. The risk is that an inventory adjustment, which provoked the July rate cut, if drawn out, could feed back on jobs and consumer spending.
Against this backdrop of soft data, negligible price pressures, and bond market expectations, not to mention Vice-Chairman Blinder's public pressure for a rate cut, Greenspan might well accede to a small quarter-point easing at the Dec. 19 meeting. A rate cut in December will do little to pump up this year's holiday sales, but it will help to spread good cheer in 1996.BY JAMES C. COOPER & KATHLEEN MADIGAN