From Christmas Blahs To New Year's Ease

While Congress and the White House play their political games over the budget, they seem oblivious to the dangers of testing the patience of the financial markets. With so much anticipation for deficit reduction already priced into the markets, Wall Street had better get some good news from Washington fast, or another 102-point tumble in stock prices and a sharp sell-off in bonds like those of Dec. 18 could be in the making.

For now, at least, the markets have taken solace from elsewhere in Washington: the Federal Reserve. The Fed's Dec. 19 quarter-point cut in short-term interest rates has soothed the markets' edginess, not so much because of that one snip but because it now looks as though more policy easing is on the way.

The strongest hint of that is the reason given by the Fed for its latest cut. Chairman Alan Greenspan cited not a soft economy but inflation that was "somewhat more favorable than anticipated." More important, he noted "an associated moderation in inflation expectations." The two-point drop during the past year in long-term bond yields, which incorporate anticipated inflation, bears that out.

If such expectations are indeed down, the Fed cannot justify holding its overnight federal funds rate nearly three full points above the rate of inflation, in light of an historical average of only about 1 3/4%. What Greenspan is saying is this: Against a more sanguine attitude toward future inflation, real short-term rates are simply too high.

Moreover, these expectations of lower inflation are not fleeting. They are set to stay down amid continued modest economic growth, an eventual budget deal, a stronger dollar, and a new order of technology-driven competitiveness in Corporate America.

THE IMPACT of these structural forces is clear in the November consumer price index, which was flat for the first time since the end of the last recession in March, 1991. The core index, which excludes the volatile energy and food sectors, rose a scant 0.1%.

Through November, annual CPI inflation was running at 2.6%, the same as in 1994, and it seems likely to have ended 1995 very near that pace. Back in July, the Fed's own forecast projected that inflation for the year would be much higher, between 3.1% and 3.4%.

Even service inflation, widely anticipated to be the first area to register a speedup, has remained modest, at about 3.4% for most of the year. Meanwhile, goods inflation, at 1.5% in November, is hardly on the radar (chart). However, that low rate is the result of deep discounting by many retailers, which threatens their profits--and for some, their very existence.

Retailers' dreary little Christmas provides additional support for a winter rate cut. Despite the expected last-minute surge, stores still reported pretty dismal sales in December. Rampant price promotions to lure shoppers subtracted from dollar revenues. The early winter weather in some parts of the nation only added to the problem. The Johnson Redbook Report said December sales at department and discount stores through Dec. 23 were 2.4% below November sales.

Lifeless sales mean that yearend profits will be a disaster for many retailers, and the consolidation process already wracking the industry will accelerate. More chains, especially regional discounters and apparel stores, are likely to seek bankruptcy protection.

The resulting liquidations could well lead to further downward pressure on goods prices. If so, an actual decline in the monthly CPI in any of the coming months cannot be ruled out.

This lack of price pressure should bolster the strong low-inflation sentiment in the bond market. And given the Fed's statement on inflationary expectations, low long-term rates will give the central bank even more room for another rate cut.

DO THE RETAIL WOES mean that the economy is tanking? Not necessarily. Much of the profits decline stemmed from price cutting, so sales on an inflation-adjusted basis should look somewhat better. Also, consumer confidence, while down slightly in December, remains at the level it has held for most of 1995 (chart).

Moreover, according to one top Fed official, the central bank is aware that the reports from individual retailers do not match the data used to calculate the Commerce Dept.'s retail sales figures. And those retail numbers do not include service purchases, which have remained healthy in recent months.

But while consumer buying is not as dramatically weak as the dour reports from retailers would suggest, demand will still be no better than modest. One reason is that in early 1996 consumers will have to contend with their holiday credit-card bills.

THE RESULT WILL BE continued pressure on industrial output and employment, as businesses adjust their inventories to more desirable levels. That scenario should translate into unexciting economic growth in the new year--another reason the Fed will have room to ease policy further.

In October, inventories held by manufacturers, wholesalers, and retailers rose 0.6%, but sales tumbled 0.4%. During the past year, the annual growth rates of both inventories and sales have been slowing, but the pace of sales has slowed faster (chart).

That disparity is the chief reason for the continued sluggishness in the industrial sector. Industrial production in November rose a tepid 0.2%, following a decline in October. Output for the fourth quarter is on track to rise even more slowly than the lackluster 3.2% annual rate posted in the third quarter.

The international economic climate is also conducive to rate cutting. Even before the Fed's Dec. 19 move, the British Treasury and the German Bundesbank had trimmed rates in the face of slower economic growth. And following the Fed, the Bank of Canada eased monetary policy as well.

Other European central banks followed the German lead, as growth throughout Europe appears to be slowing, leading most private forecasters to cut their projections for 1996 European growth. Almost all industrialized nations reported weak holiday sales.


Consequently, the dollar should be able to maintain its recent trend of appreciation against the German mark and the Japanese yen, even in the face of further rate reductions by the Fed. The greenback will get some added support when a budget deal rolls in from Washington--whenever that may take place.

That delay, however, will not hamstring monetary policy. In the recently released minutes of the Fed's Nov. 15 meeting, the central bankers agreed that the Fed "could not freeze its policy options while it awaited the outcome of a prolonged federal budget debate."

Now that Shutdown II has stretched to record length, the Fed's refusal to be tied to the political wrangling means that economic and inflationary forces will set the course of monetary policy in early 1996. And right now, those forces point to further easing ahead.

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