U.S.: Why The Fed Didn't Go For A Full Strength Rate Cut

While growth is set to slow, U.S. conditions don't call for stronger action

Call it Fed Lite. After thirsting for a full-bodied cut in interest rates, financial markets in the U.S. and around the world were very disappointed with the Federal Reserve's quarter-point trimming of its federal funds rate, to 5.25%, on Sept. 29 and its decision to leave the domestically symbolic, but internationally important, discount rate unchanged at 5%. The cautious move suggests that domestic concerns remain the Fed's primary consideration in setting policy. However, the fact that the bank moved at all implies that global turmoil influenced the Fed's decision.

To be sure, U.S. growth is set to slow, and that was a key reason the Fed acted. Consumers can't keep up their frenetic first-half pace, especially now that their confidence has slipped a little. And businesses are certain to curb capital spending in response to falling profits and costlier financing. Also, manufacturing output and employment will continue to suffer, as exports weaken further (chart).

But under normal circumstances, current economic conditions are far from dire enough to have provoked the Fed to trim the federal funds rate by even a quarter point. In fact, a slowdown that would halt the steady tightening in the labor markets is something that the Fed has wanted to see all year. Plus, there is as yet no evidence to gauge the degree to which the economy is going to slow.

HOWEVER, THE FED'S ACTION suggests that these are not normal circumstances. The central bank seems to be saying, although not very loudly, that in an increasingly global economy, U.S. policy can no longer operate in the vacuum of the domestic economy.

In addition, the rate cut appeared to acknowledge that the collapse of emerging markets is exerting intense pressure on pockets of the U.S. financial system. Only one week before the meeting, Fed officials mediated the $3.6 billion bailout of the hedge fund, Long-Term Capital Management. The unusual intervention was seen as a Fed move to head off any systemic risks in the financial markets.

The statement accompanying the rate cut said that the Fed wanted to "cushion" the economy from increasing foreign weakness and less accommodative domestic financial conditions. In particular, a growing aversion to risk is causing less credit to be available. The Fed also said that because of "recent changes in the global economy and adjustments in U.S. financial markets," a slightly lower federal funds rate would be consistent with low inflation and continued growth.

Still, the small move was not the shot heard 'round the world that many investors were looking for. The markets had held out hope for a half-point cut in the federal funds rate. And most Fed watchers were also looking for a half-point lowering of the discount rate, which could have held out the promise of more easing to come. However, nothing in the Fed's action or statement indicated that more cuts were in the cards.

ON PURELY DOMESTIC GROUNDS, the lower fed funds rate can be justified as insurance against a recession, especially since the global genesis of the expected slowdown is unique in the postwar era, making it more difficult to gauge the fallout. So far, signs of a slowdown are skimpy, but the latest one was the drop in September consumer confidence. The Conference Board's index fell to 126, the third decline in a row. The board said that global financial turmoil, a shaky U.S. stock market, and the President's uncertain future contributed to the sag in household spirits.

The decline in confidence was almost solely due to diminished expectations about the future (chart). Consistent with recent upbeat data on spending, consumers said that present conditions remained very near the best in three decades. However, the index of expectations dropped sharply. The three-month decline in expectations, totaling 17.5%, is the largest in five years. In the past, a plunge of that magnitude was typically followed by some slowdown in spending.

Any big pullback will not show up before the fourth quarter, however. That was clear from August's 0.5% jump in real outlays for goods and services. The increase followed a 0.3% drop in July, when car sales plunged due to the strike at General Motors Corp. and the end of generous dealer incentives. But even with the July slump, third-quarter consumer spending is probably growing at an annual rate in excess of 3%, and excluding motor vehicles, the advance will be in the neighborhood of 5%.

However, households cannot sustain that frenzied shopping pace. That's because the nearly 5% growth in spending over the past year has exceeded the 3% clip of consumers' aftertax income (chart). Consumers have been able to supplement their buying power with realized gains in their stock portfolios. But those same gains meant consumers were less inclined to save. The August saving rate of 0.3% was the lowest rate on record, except for June, when the rate was zero. In coming months, the stock market's correction will force many consumers to save more--and spend less.

BUT CONSUMER SPENDING is not the economy's most vulnerable sector right now. That distinction goes to capital spending. Business investment in new equipment and buildings is getting hit from all sides. Profits are under severe pressure with little relief in sight. Weaker stock prices have lifted the equity cost of capital. New market assessments of risk have raised borrowing costs for all but those companies with the most sterling credit ratings. And the economic slowdown will cut incentives to expand already plentiful capacity.

Manufacturers' capital-spending plans are likely to take an especially severe hit. Factories are already reeling from this year's plunge in exports, which is showing up in the weakening trend of new orders for durable goods. Factory bookings jumped 1.6% in August, but they have been volatile recently because of the GM strike and a bunching of aircraft orders. Excluding the transportation sector, August orders dropped 2.1%, and they are clearly drifting lower.


Capital-goods orders, excluding aircraft, are holding up fairly well through August, but the growth rates from a year ago in both orders and shipments of equipment have been slowing progressively throughout the year. With capital-spending fundamentals now increasingly negative, further slowing is a good bet.

A quarter-point rate cut won't do much to dampen those odds. And it was the weakness of the Fed's move that left the markets thirsting for more. However, the Fed likely recognized that economic growth is not yet easing enough to raise recession worries. And until policymakers see hints of severe slowing--or more chaos in the financial system--they will probably keep the full-strength rate cuts untapped.

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