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The Odds Shorten on a Rate Cut

By Michael Englund The financial markets were somewhat relieved that the figures in the October employment report, released Nov. 1, were slightly stronger than expected. But that hasn't stopped the bond market from fully pricing in an interest-rate cut by the Federal Reserve at its policy meeting on Wednesday, Nov. 6. Wall Street assumes that the Fed has plenty of room to ease again and will respond to recent reports showing some downside risk to economic growth.

These economic numbers have been skewed by temporary distortions resulting from the West Coast port dispute. Indeed, the underlying data can easily be seen as consistent with 3% gross domestic product growth.

PIER PRESSURE. The markets, however, are spooked. Though we at MMS International continue to expect GDP growth to remain near 3% through the second half of 2002, we now assume that Federal Reserve Chairman Alan Greenspan will capitulate to rate-cutting pressure from both the markets and Federal Open Market Committee members, who dissented from the policymaking committee's steady stance at its last meeting. We expect Greenspan & Co. to cut the benchmark Fed funds target rate by 25 basis points, to 1.5%, at the meeting.

The absence of the widely feared downside shock in the employment report has taken some of the air out of the pessimists' argument for strong action by the Fed. But the persistent sluggishness in job growth and concentrated weakness in the factory sector have strengthened the case of those who believe that the risks to the economy have increased -- and this is reason enough for the Fed to act.

What's clear is that nearly everyone has underestimated the impact that disruptions from the dock-worker lockout are having on the current economic data. The recent data releases on factory orders, employment, the Institute for Supply Management index of national manufacturing activity, and auto-industry sales figures were substantially affected by the trade disruptions, as managers in a variety of industries, including the important auto sector, have confirmed.

TRENDING DOWN. In the October employment report, the work week fell sharply for the transportation and wholesale sectors -- those that would have been most affected by the dock-worker disruptions. The work week experienced declines of 0.5 hours and 0.4 hours, respectively. It fell by 0.2 hours in the factory sector, the area after transportation and wholesale that would have experienced the greatest disruption. Similarly, payrolls in all three sectors have weakened over the past three months, following three months of strength brought about by increased production and shipment of goods in anticipation of the impending labor conflict.

The lockout had a clear impact on trade figures. Imports of goods soared by 28% in the second quarter, but grew at only a 4.5% yearly rate in the third quarter -- and are poised to contract in the fourth. Exports of goods grew at a 16% rate in the second quarter before slowing to a 3.8% rate in the third. Exports are expected to shrink in the fourth quarter. Swings in the labor market translate into similar ones in industrial production, which we expect to drop 0.4% in October -- the third consecutive monthly decline -- following three months of hefty gains.

In the auto sector, vehicle assemblies fell by 5% in October, the third month of declines. Auto-industry executives have linked some of the production shortfall to the West Coast labor dispute. Carmakers seem to disproportionately affect another widely followed manufacturing gauge, the Chicago ISM index, and the weakness in this report for October also paralleled these likely trade-related gyrations. Finally, the durable-goods orders figures released last week were probably also part of this trade distortion.

IRRESISTIBLE FORCES? Overall, it appears that economic growth is slowing marginally in the fourth quarter and that the risks to the economy have increased. But if the likely trade distortions are taken into account, the gyrations are in line with normal swings in GDP data.

Nevertheless, the slight increase of the risk of economic weakness will give the Fed plenty of room to ease policy on Nov. 6. And Greenspan, who has wanted to keep his powder dry after an unprecedented string of 11 easings since January, 2001, will be under considerable pressure from both markets and some of his FOMC brethren to cut rates. Englund is chief economist of MMS International

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