If You're Looking For A Rate Cut, You'll Have To Wait

The Federal Reserve has a lot to ponder at its next policy meeting on May 23. Suddenly, the domestic part of the economy looks downright sickly in the second quarter, and inflation appears to be accelerating a bit. At the same time, Capitol Hill seems to be getting its budget-balancing act together--something that has added support to the recent rallies in both bonds and the dollar. What's the Fed's next move?

The economy's paler cast strongly argues that the Fed's next action will be a rate cut. After all, in February, top Fed officials said the central bank will ease policy preemptively in order to avoid recession in much the same way it tightened earlier to nix inflationary pressures.

However, an easing move still seems to be a long way off. To be sure, the slowdown signals are increasingly ominous. In April, industrial production, real retail sales, and housing starts each began the second quarter well below their first-quarter levels. About the only things that began this quarter higher than last quarter are new jobless claims, inflation, and probably inventories. Not a comforting mix.

LOOK CLOSER at the economy's weakness and underlying supports, however, and there is little to indicate that the Fed has overtightened. Excess inventories are mostly to blame for the factory sluggishness. Sturdy income growth means that consumers have plenty of cash to spread around at their local malls. And the steep decline in long-term interest rates of late will provide stimulus for housing and other sectors of demand, even without an immediate Fed easing.

The slowdown is fundamentally a midcycle inventory correction. Although many industries are nursing excess inventories, the correction is also disproportionately concentrated in the auto industry. Removing that logjam alone, which should be accomplished by summer's end, will provide a lot of relief.

Moreover, excess inventories in the retail sector include many imports, which will mitigate the impact of fewer retail orders on U.S. manufacturers. Also, U.S. manufacturers' reaction times to overstocking have become so rapid in recent years that the output adjustment will be much faster, with less chance that a severe inventory problem will develop.

In the meantime, the Fed will have to keep at least one eye on inflation. Both the producer and consumer price indexes in April were a little unruly.

The CPI jumped a defiant 0.4% in the month, as did the core index, which omits energy and food because they often distort the trend. For the past six months, core consumer inflation stands at an annual rate of 3.4%. That's the fastest six-month rate in nearly two years, and it's up from 2.8% in the previous half year.

If monthly increases in the core index alternate between 0.2% and 0.3% for the rest of the year--a likely result--core inflation will end 1995 at 3.5%. Even under that tame scenario, the core rate will accelerate nearly a full percentage point, from 2.6% in 1994.

THE FED has suggested, however, that it will tolerate at least a mild pickup in inflation as long as the economy shows clear signs of slower growth. And does it ever. Retail sales fell 0.4% in April. Even excluding a sharp drop in car-buying, sales elsewhere still managed only a slim 0.1% gain. Demand for durable goods generally was weak, with sales declines in both building materials and furniture as well as autos.

Early-bird signs for May, however, indicate that consumers haven't given up shopping for good. Retailers gauged sales in the second week of the month as generally "on or above plan," according to key weekly surveys. The two leading roundups each show that seasonally adjusted sales in the first two weeks of May stood about 0.4% above April's level.

Amid price hikes and still-high financing costs, car sales will be slower to come around. Unit sales of cars and light trucks in April fell to an annual rate of 13.8 million, the fewest since last July. Although Detroit already pared down April output substantially, further cutbacks in May and June will be needed to rein in bulging dealer inventories.

Apr. 30 dealer stocks of U.S.-made vehicles jumped to an 82-days' supply for cars and a 78 days' total for trucks. Both are far above the more desirable 60 days, suggesting that, without stronger demand, planned May and June output reductions may not be enough.

Motown's weakness hit the nation's industrial production hard in April. Although output in mining and utilities rose, production in manufacturing dropped 0.5%, the third straight monthly decline, something that hasn't happened since the rough early days of this expansion. About half of the April drop reflected a steep 4.4% plunge in output of motor vehicles and parts. And the weekly BUSINESS WEEK production index indicates output continued to slip in early May.

Paralleling the recent retail-sales weakness, output of consumer goods was especially soft in April, including further cutbacks in production of household appliances and furniture. Weak auto and truck output also dragged down production of business equipment. That was the first monthly decline in three years, but output of information equipment continued to rise strongly, providing a key support under production.

THE HOUSING SLOWDOWN continued to hit output of construction supplies. April housing starts did not rebound from their steep 6.7% decline in March, as many analysts had expected. Construction of homes and apartments edged up 0.4% in the month, to an annual rate of 1.24 million. Still, lower mortgage rates are improving the mood of builders, says the National Association of Home Builders.

The trade group's new housing-market index, a measure of market health and builder confidence, rose in May to the highest level since December. Builders said buyer traffic was marginally higher in May after declines in previous months, and their expectations for sales in coming months were up. The reason: Mortgage rates averaged a 14-month low of 7.87% in early May, says the Federal Home Loan Mortgage Corp.

For the Fed, the bright spot in the production adjustment is the sharp decline in the rate of capacity use, a sign that markets have more slack and price hikes will be harder to pass on. Operating rates in manufacturing fell 0.8 percentage point, to an average of 83.5% in April. That's down sharply from the recent peak of 85.2% in January.

The economic slowdown, combined with prospects for serious deficit reduction, is paving the way for an eventual easing of Fed policy that will help to extend this expansion, already four years old. Done over seven years, budget-cutting will create a minimal fiscal drag in any given year that can be offset easily by lower interest rates.

But the soft-landing scenario is only now beginning to play out. The Fed will need a lot more evidence that things are going its way before it's willing to make a major policy shift.

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