U.S.: The Fed Takes Out Some Insurance

Fears of inflation wither next to the threat of recession

Financial markets in the U.S. and abroad were hopeful that the Federal Reserve would trim interest rates again at its policy meeting on Nov. 17, and they were not disappointed. The latest cut, coming after stronger than expected third-quarter economic growth and amid signs of continued resilience in the fourth quarter, means that the Fed is committed to assuring that financial-market instability will not push the economy into a recession in 1999.

The Fed's rapid-fire reaction to global market turbulence this summer has been remarkable. After a quarter-point cut, on Sept. 29 and again on Oct. 15, in an unusual between-meetings move the Fed has now lowered its federal funds rate by another quarter-point, to 4.75%. It also trimmed its discount rate by a quarter-point, to 4.5%. But what makes these three cuts in seven weeks unique is that they have come in an economy that has grown at a 3.5% annual rate so far this year and with the unemployment rate at an unusually low 4.6%. Clearly, the Fed's current focus is on the financial markets.

Very simply, the Fed opted for some low-cost insurance that the recent improvement in financial conditions will continue. Why low-cost? Because with slower economic growth likely and with the October price indexes still tame, the recession risk associated with not reducing rates is greater than the inflation risk of cutting too much.

IN TAKING ITS NOV. 17 ACTION, the Fed said that although market conditions have "settled down materially since mid-October, unusual strains remain." Various risk spreads between the yields on riskless Treasury bonds and riskier corporate debt have narrowed, but they remain wide by historical standards, suggesting that credit is still hard to come by for some borrowers (chart). Also, the recent market calm looks tentative, given still shaky global conditions.

Moreover, despite the firmer look of the economy in recent weeks, highlighted by strong retail sales and car buying in October, the Fed believes that the slowdown forecast is still the best bet for 1999. Indeed, the economy seems unlikely to push ahead at this year's robust pace under the weight of falling exports, stagnant industrial output, falling profits, generally tighter credit conditions for businesses, and a new round of layoffs.

Where does policy go from here? Based on the Fed's statement, the latest cut, amid firmer financial markets and resilient economic data, appears to diminish the chances for another cut at the Dec. 22 policy meeting. The Fed said that given the three rate cuts since Sept. 29, "financial conditions can reasonably be expected to be consistent with fostering sustained economic expansion while keeping inflationary pressures subdued." In English, barring further market turmoil, the cuts to date should bring financial conditions in line with where the Fed wants them to be.

But much will depend on the markets. The policymakers did not slam the door on a Dec. 22 rate cut. By also lowering the discount rate on Nov. 17, the Fed implicitly told the markets that it is leaving the door open for another move, if needed.

THE FED WILL KEEP A KEEN EYE on the economy, as well. So far, the economic slowdown is developing only gradually, mainly because the economy's weakness remains concentrated in exports and manufacturing, while overall growth continues to get plenty of support from consumer spending (chart).

In fact, consumers are giving fourth-quarter economic growth some solid support. Retail sales jumped 1% in October, the largest gain since May, fueled by a surge in car buying. But even excluding autos, retail purchases in the month still rose a healthy 0.5%. Consumer spending, as measured in the gross domestic product numbers, is on a track to post growth at an annual rate of 4% or more, which would be little changed from the third quarter's robust clip.

But that figure will mask a slowing trend. Fourth-quarter car buying is up from a low third-quarter level, which was depressed after spring buyer incentives ended and during the strike at General Motors Corp. Excluding autos, consumer spending is set to post its slowest quarterly growth of the year.

Also, slower inventory growth could be a large offset to overall GDP growth this quarter. With factory output stagnant, and with car dealers' lots restocked after the GM strike, additions to stockpiles are set to slow, perhaps sharply. September business inventories rose 0.6%, much faster than the Commerce Dept. assumed when it calculated third-quarter GDP. The result: Stronger than expected September inventories will boost third-quarter GDP even more, but the falloff in stock-building this quarter could be sizable.

THE FED IS WELL AWARE that the latest data clearly show the economy's areas of weakness, and foreign trade is a key one. The September trade deficit narrowed from its record of $15.9 billion in August, to $14 billion, but the improvement is likely to be temporary. A large monthly blip in aircraft exports, which tend to be volatile, accounted for all of the shrinkage. The Boeing Co. shipped twice as many planes abroad in September as they did in August, and October shipments were scheduled to fall back.

Exports are still in their sharpest decline since the early 1980s, and that is the chief reason why manufacturing output through October has gone nowhere since the beginning of the year--and why factory payrolls are shrinking. Factory production rose 0.3% in October, but the trend looks much weaker. Excluding motor vehicles, manufacturing output has fallen in three of the past five months (chart). After declining in the third quarter for the first time since the 1990-91 recession, production in October was below the third-quarter average, suggesting a second consecutive quarterly drop. Also, manufacturers used only 79.4% of their production capacity in October. Strike-adjusted, that's the lowest utilization rate in six years.


No wonder inflation is a no-show. Producer prices for finished goods remained exceptionally tame in October, and excluding energy and food, core prices at the earlier stages of production are falling, strongly suggesting the absence of any pricing pressures in the pipeline. At the consumer level, the consumer price index increased a modest 0.2% in October, as did the core CPI. The annual inflation rate in October stood at 1.5%, with core inflation running at 2.3%.

With the economy set to slow, there is little to suggest any significant acceleration in inflation in the coming months. And that is the chief reason to be optimistic about 1999. More than anything else, low inflation has given the Fed the leeway to act quickly and decisively in the face of financial-market stress that could threaten the economy.