Gradualism is back in vogue at the Federal Reserve, but it appears to have been the result of compromise, not unanimous consent. After an unusually bold series of five half-point cuts in interest rates, growing dissension within the Fed's ranks over the size and speed of cuts appears to have played a key role in the policymakers' June 27 decision to shift back to quarter-point cuts.
The discord seems odd at a time when the economy is still obviously weak, but it is also a sign that the Fed is starting to grapple with the risks associated with its self-described "rapid and aggressive" policy. The problem: Given the huge amount of stimulus already in the pipeline, and given the uncertain lags between policy changes and their impact on growth, policymakers are more in the dark than usual about how much easing is necessary and how much may be too much.
One implication of the Fed's new caution is that the easing cycle is almost finished. Obviously, a lot will depend on the data this summer, and the Fed still believes that the risks in the outlook are tilted toward economic weakness. But the latest data on consumer spending, factory inventories, industrial activity, and jobless claims suggest that the economy was a bit stronger at the end of the second quarter than it was at the start (charts).
Consequently, if the numbers continue to hint that the worst of this slowdown has passed, one more quarter-point cut at the Fed's Aug. 21 meeting would be the last easing move, and the Fed would likely shift its view of the outlook to neutral, meaning that the risks of weak growth and higher inflation are evenly balanced.
THE RETURN OF GRADUALISM may have hinged on four concerns underlying Fed policy. First, heading into the meeting, Fed Chairman Alan Greenspan--who typically sounds out voting members beforehand--may have known there was no consensus for a half-point cut. Second, the barriers to a second-half pickup seem to be diminishing. Third, some policymakers are beginning to worry about overeasing. And last, the Fed loves to have ammo at the ready. Why waste a supersize cut when a smaller one will do?
The first reason for baby steps, a possible lack of consensus, could only be guessed at on June 27. The biggest piece of evidence was the brevity of the Fed's statement. Unlike the notes announcing previous cuts, in which the Fed spelled out its concerns, this statement was almost boilerplate in its language, as if the individual policymakers could not agree on a more detailed view of the economy.
But clear evidence of a policy split came to the fore on June 28, when the Fed released the minutes of the May 15 meeting. Those minutes offered the surprising news that Kansas City Federal Reserve Bank President Thomas M. Hoenig voted against the Fed's half-point cut last May, preferring a "less aggressive easing action," and that two other members who voted for the half-point cut said they could have supported a less aggressive move. Outright dissent is unusual, since the Fed prefers to present a unanimous front.
In addition, the entire policy committee agreed back in May that the Fed might soon have to shift its outlook toward a more balanced assessment of the relative risks between economic weakness and future inflation. Moreover, the minutes said that such a shift would come "probably well before substantial evidence had emerged that economic growth had strengthened appreciably." The Fed concluded that, absent adverse shocks, the amount of further easing was unclear, but it also said that "some members noted that the end of the easing process might be near."
THE ARGUMENT to end rate-cutting altogether is based on the second reason for more caution: There is nascent evidence that the economy has already weathered the harshest elements of this slowdown, and growth in the second half will be healthier.
On that front, stalwart consumers remain the economy's greatest hope. Households increased their price-adjusted purchases by 0.3% in both April and May. That means real consumer spending is on track to grow at an annual rate of at least 2.5% in the second quarter.
That solid pace probably offset the drag from a wider trade gap and declines in capital investment during the spring months (chart). And households kept up their spending despite a weaker job market in the second quarter. By late June, though, new claims for jobless benefits, which tend to foreshadow job-market trends, fell sharply. And household confidence was brighter in June, in part because consumers think job prospects will be better in the second half.
Even the manufacturing data looked a bit better in June than in May. The purchasing managers' index, a composite of production, orders, employment, inventories, and delivery times, rose to 44.7% last month from 42.1% in May. The orders and production indexes both showed significant gains. But because the PMI remains below 50%, the index is only suggesting that the manufacturing recession is not worsening. There are no signs that the factory downturn has ended.
IF THE OVERALL ECONOMY is set to show better growth in the second half, however, certain resources, most notably the labor markets, have not loosened up enough to keep cost pressures from becoming a problem in 2002. This fear bolsters the third argument for gradualism: Too much stimulus may already be in the pipeline. As Fed Governor Laurence H. Meyer warned in June: "We have to be concerned that as we ease to mitigate the risks of a persistent slowdown or recession we do not at the same time create conditions that lead to higher inflation as the expansion gathers momentum." The concern is that rising labor costs could trigger a new round of price pressures, and the Fed could be forced to start hiking rates early next year.
Such a quick turnaround in policy would open the Fed to sharp criticism, as happened in late 2000. Back then, when the economy slowed dramatically, some analysts and business executives griped that the Fed's May, 2000, half-point rate hike was overkill. They said the economy was paying for the Fed's mistake.
Of course, Greenspan & Co. denied any misjudgment, but monetary policy is not an exact science. That's why the Fed likes to use its ammunition sparingly unless drastic measures are needed.
Right now, the betting is that the Fed will move another quarter-point in August. But if the data turn surprisingly sunny, or if the tax rebate unleashes more consumer spending than is now expected, don't be surprised if the Fed keeps its guns holstered. Whether the bank fires one more time or not, the uncertainty of the economic outlook, coupled with the latest signs of dissension at the Fed, suggest the August powwow will be a spirited affair. By James C. Cooper & Kathleen Madigan