Forget The Critics: The Fed Made The Right Play

Did the Federal Reserve jump the gun when it lowered interest rates by a quarter point at its July 6 policy meeting? If the Fed had known prior to its powwow that June payrolls had risen strongly and that the jobless rate had fallen--as was reported the following morning--would a rate cut aimed at bolstering a sagging economy still have seemed justified?

If not, the only other explanation would be that the Fed succumbed to political and market pressure. The markets had anticipated a rate cut for weeks. Not giving it to them might have reversed the recent rallies, especially in bonds, thus thwarting gains in housing and dampening economic prospects generally.

Also, Fed Chairman Alan Greenspan, up for reappointment next March, must go to Capitol Hill on July 19 to make his semiannual defense of monetary policy. That testimony will come at a time when economic growth looks awful and after Clinton-appointed Vice-Chairman Alan Blinder has strongly hinted that the economy needs lower rates.

Indeed, not only is second-quarter growth in real gross domestic product due for a poor showing when the Commerce Dept. issues its report on July 28, but the Fed also is well aware that first-quarter economic growth will look decidedly weaker when Commerce makes sweeping changes to GDP in December.

Commerce will shift to a new type of GDP measurement that will correct an overstatement of recent growth in many sectors, especially output of computers and related equipment. Based on current data, first-quarter growth would be 1.7% instead of 2.7%.

BUT ALL THIS misses a key point: The Fed's cut in the overnight federal funds rate from 6% to 5 3/4% was based not so much on how the economy is faring now but on how it will look a couple of quarters down the road. That's when the impact of lower rates will show up. In that regard, the June employment report tends to support the Fed's action, not discredit it.

The job numbers give no evidence that growth is going to come roaring back in a way that would dissuade the Fed from believing inflation is under control. To begin with, the June gain of 215,000 nonfarm jobs was overstated. The Labor Dept. said that 50,000 to 100,000 of those new jobs could be explained by the unusually long interval between surveys.

Because the time between surveys was five weeks instead of the usual four, payrolls in three seasonal industries--restaurants, amusement and recreation services, and construction--rose by a total of 104,000. Those industries account for only 12% of all jobs.

Even with the strong June increase, and allowing for Labor's revision to May payrolls, which cut in half the originally reported 101,000 decline, job growth averaged a paltry 59,000 per month last quarter, down from 226,000 in the first quarter (chart).

Moreover, the drop in the jobless rate to 5.6%, from 5.7% in May, looks suspect. Although new jobless claims appear to have peaked in late June, the rise in claims this year is historically consistent with an unemployment rate closer to 6%. A higher jobless rate later this summer or fall seems assured.

INTERESTINGLY, the only pieces of the employment report that were available to the Fed at its meeting were those from manufacturing, mining, and utilities. The Fed research staff receives that data early in order to calculate its monthly index of industrial production. And the factory sector was the weakest part of the employment report.

Manufacturers let go 40,000 workers in June, the third decline in a row, bringing losses since March to 104,000. The May and June drops were the broadest in 3 1/2 years, with the largest payroll declines occurring in transportation equipment and apparel, two industries facing large inventory adjustments.

The good news, though, is that manufacturing may be stabilizing, as the inventory correction runs its course. The factory workweek rose by 6 minutes, to 41.5 hours, following three months of declines. The rise suggests that the reductions in output necessary for businesses to adjust their stock levels are starting to wind down. Indeed, inventory growth in the wholesale sector took a sharp downward turn in May (chart).

The key question is: Where does the Fed go from here? The Fed's official explanation on July 6 said, "inflationary conditions have receded enough to make a modest adjustment in monetary conditions." Fedspeak aside, in the past a "modest adjustment" has rarely been limited to a mere quarter point, which the economy will barely even feel.

Further cuts would be consistent with a key policy guideline called Taylor's Rule, which tries to balance policy actions against a prescribed goal for inflation while also taking into account economic growth. Policy under Greenspan has tracked this rule very closely.

By Greenspan's own standard of real interest rates, policy is quite restrictive. With inflation expected to be about 3 1/2% by yearend, the current real federal funds rate is 2 1/4%, well above the 1 3/4% historical norm. By this measure, it would take another half-point cut to shift policy to a more neutral impact.

Also, the Fed may have been thinking ahead to the fiscal drag that will hit the economy next year as a result of Washington's efforts to trim the deficit.

IMPLICIT IN THE FED'S move is a bet that inflation will stay under control. It's a good bet. While second-half economic growth is set to pick up from the second quarter's dismal showing, it is not likely to exceed the Fed's noninflationary speed limit of about 21/2%. The index of leading indicators fell 0.2% in May, the fourth drop in a row. Past rate hikes will still be a drag on demand, and the negative effects of the inventory correction may hang around through the third quarter.

Even so, consumers appear to have ended the second quarter stronger than they started it. Car buying picked up in June, thanks to the widespread use of incentives. Purchases of U.S.-made cars and light trucks rose to an annual rate of 12.7 million, up from 12.5 million in May and 11.9 million in April. Also, weekly pay increased in June, rebounding 1.3%, thanks to both higher hourly wages and a longer nonfarm workweek, suggesting better income growth.

Household finances will also improve because of the lightning speed with which banks cut their prime rates, from 9% to 8.75%, after the Fed's move. That quickness shows keen loan competition and implies a generous flow of credit through the economy.

The Fed will clearly keep a sharp eye on wage growth, since its pace continues to drift higher (chart). But that slight pickup has been more than offset by productivity gains. So unit labor costs--the main determinant for prices--remain tame.

For now, the June employment report says that the worst of the weakness is probably over, and that recession is not a worry. What the Fed's rate cut says is: As long as growth remains moderate, a pickup in the economy need not preclude even lower rates.

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