The Fed Jumps In For Some Second Half Help

Two things seem certain this summer: The "Dream Team" will bring home the Olympic gold in basketball, and the U.S. economy will be a continuing source of disappointment. The shockingly weak job data for June make the latter point painfully clear. However, the economy does have one player on the bench that it can count on to prevent a rout: the Federal Reserve.

On July 2, the Labor Dept. reported a large and broad shrinkage in June payrolls. Job losses totaled 117,000 at a time when most analysts expected a gain of that magnitude. And the unemployment rate jumped to 7.8%, from 7.5% in May and 7.2% in April, as the labor force continued to surge ahead of the economy's ability to create new jobs (chart). Last month's jobless rate was the highest since March, 1984.

Less than an hour after the release of the employment report, the Fed cut its official discount rate for the seventh time since its peak in December, 1990, and it trimmed the market-moving federal funds rate for the 17th time since the recession began in July, 1990. The discount rate now stands at 3%, and the Fed's new target for the federal funds rate is 3 1/4%. Both levels have not been seen since the Kennedy Administration.


The rate cuts will help to keep the economy dribbling along this summer, but with the recovery already facing tough opposition, growth isn't likely to score on any dazzling drives to the basket. Commercial banks wasted no time cutting their prime rate from 6 1/2% to 6%, which lowers the cost of various consumer loans. Short-term market rates fell in tandem with the federal funds rate, and long-term rates declined as well.

Lower long-term rates are the best news. They have been stubbornly high, particularly in relation to short-term rates. After hovering above 8% in early May, the rate on 30-year Treasury bonds fell to 7.6% by July 8, only a bit above the five-year low of 7.4% hit back in January. And long rates may well head lower.

The reason: The dismal job data drove home the point to the bond market that a recovery strong enough to pressure inflation is just not in the cards. Also, the likelihood of any tightening of Fed policy for the rest of the year now seems equally improbable.

Rate declines will breathe life back into housing demand, but a strong response isn't likely with consumers facing slow growth in jobs and incomes and the need to repair their fragile finances. Still, housing had faltered this spring largely because mortgage rates had risen.

But by July 3, the average fixed rate on 30-year mortgages was already down to 8.43% from 8.52% the week before, according to HSH Associates. When the full impact of the Fed's actions are felt, 30-year mortgages will challenge January's 20-year low of 8.31%, which fueled big housing gains earlier this year.

But the biggest benefit of lower interest rates in a debt-burdened economy is the opportunity for consumers and businesses to refinance their debt. Refinancing is a crucial part of the reliquification process that is necessary for a lasting recovery. It boosts cash flow for businesses and puts more money in consumers' pockets.

The Fed gave three reasons for its latest moves. Listed in order, which is usually a ranking of their importance, it cited slow money growth, low inflation, and an uneven recovery. The Fed's favorite measure of the money supply, M2, fell a steep $10.6 billion in the week ended June 22. The drop continued a pattern of weakness that began in March (chart).

Many economists--and the Fed itself--had begun to play down the importance of M2 in the outlook. As long as the recovery looked solid, money growth below the Fed's target could be dismissed as an aberration.

Now, the central bank may reassess that view. Slow money growth along with a struggling economy would be grounds for the Fed to pull the trigger on yet another easing move this summer, if that combination persists. But as far as half-point cuts in the discount rate are concerned, the Fed has only six bullets left.


The June employment report makes another rate cut a real possibility. The disturbing feature of the job losses was their breadth. Of the 356 industries surveyed, only 43% added workers to their payrolls last month. That was the lowest percentage since April, 1991.

Goods producers bore the brunt of June's job losses, as factories trimmed their payrolls by 58,000 workers and construction handed out 32,000 pink slips. But service producers also made cuts. Jobs in retail and wholesale trade fell by 20,000 and 16,000, respectively. Business, health, and other personal services--normally a strong sector--let go 15,000 employees.

However, the June data may well overstate the economy's problems. The consistency of the weakness in the payroll indicators, coming after fairly uniform signs of strength in May, suggests a quirk in Labor's seasonal adjustment. The June survey was done earlier than usual, and that may have understated student employment.

The job trend remains upward. The three-month average of jobs continued to rise in June, reflecting payroll gains of 177,000 in April and 93,000 in May. That's unlike last November, when the three-month trend began to fall, signaling that the recovery was faltering.

Nevertheless, the job numbers put the handwriting on the wall for second-quarter gross domestic product. Hours worked, an indicator of overall output, rose at an annual rate of 0.7% last quarter, down from 1.1% in the first quarter. Unless productivity growth exceeds its first-quarter pace, which is unlikely, real GDP will fall short of the first quarter's 2.7% gain.


The recovery's biggest problem is the absence of a healthy consumer sector, which is two-thirds of GDP. Consumers' troubles are twofold: Heavy debts have left households in poor financial shape, and the permanent nature of recent job losses is a drag on the income growth that is necessary for households to mend their balance sheets (chart). The Fed's rate cuts address both of these problems, but solving them will take time.

Income growth was certainly lacking in June. Average hourly earnings rose by 2 cents last month, to $10.58. That small rise plus the shorter workweek--34.3 hours compared with 34.6 hours in May--and the June job losses imply a weak showing for personal income.

If there is a bright side to slower wage growth, it is the absence of wage pressure on inflation. Indeed, hourly earnings last quarter were up only 2.4% from a year ago, the slowest yearly pace since 1987.

Still, judging by the recent pickup in car sales, consumers are not in such dire straits that they are ready to throw in the towel. Sales of domestically made autos jumped in late June to an annual rate of 7.6 million, bringing the monthly pace to 6.8 million. Fleet sales to rental-car companies lifted car buying in late June, but still, the monthly pace was the strongest in 18 months.

Moreover, those sales numbers do not capture the growing importance of light trucks, such as minivans and jeeps. Sales of U.S.-made light trucks jumped to an annual rate of 4.5 million in June (chart). Since January, car sales are up 15%, but sales of cars and trucks together are up 21%. The trend suggests that vehicle demand is stronger than the car numbers alone imply.

Rising car sales may be a sign that consumers are not making much progress in lightening their debt burdens, however. Installment debt outstanding, down by $2.4 billion in May, has been shrinking for more than a year, but that's mainly because of falling auto credit. Rising car sales suggest that consumers are substituting leasing and home-equity loans for traditional installment loans. Consequently, nonauto installment debt as a percentage of aftertax incomes remains very high.

Working under the twin burdens of fat debts and skinny wallets, the performance of consumers this summer will be far from Olympic. But thanks to the Fed, lower interest rates will help keep them in the game.

    Before it's here, it's on the Bloomberg Terminal. LEARN MORE