U.S.: What Greenspan Saw In The Data
What a way to ring in the new year. Coming after another one-day plunge in the Nasdaq, a drop in consumer confidence, and a purchasing managers' report that confirmed the manufacturing sector is in recession, the Federal Reserve decided it could wait no longer to see how the 2001 economy would play out. And so, in a stunning move on Jan. 3, policymakers cut short-term interest rates. More important to the outlook, the Fed suggested more cuts could be on the way.
The Fed said that its action to cut the federal funds rate by a half-point to 6%, and the discount rate by a quarter-point to 5.75%, was "taken in light of further weakening of sales and production, and in the context of lower consumer confidence," as well as tight financial conditions and high energy prices that are "sapping household and business purchasing power."
The stock market, long battered by recession fears, soared on the news. The Dow Jones industrial average ended the day up 300 points, while the Nasdaq surged by 325 points. The dollar climbed sharply versus the euro, as the Fed's aggressive move convinced foreigners that U.S. investments will remain the most attractive in the world.
Moreover, the Fed reiterated that its concerns for the outlook remain tilted "toward conditions that may generate economic weakness in the foreseeable future." Translation: More rate cuts could be on the way, perhaps as early as the Jan. 30-31 meeting, depending on how the upcoming data play out.
The move is unequivocally positive for both the financial markets and real economic activity, although Wall Street will feel the effects before consumers and businesses. Much of the economic data will undoubtedly remain on the soft side through the winter, but the Fed's decisive action now clearly lessens the risk of a recession and heightens the chances for a soft landing.
THE TIMING OF THE RATE CUT, between scheduled policy meetings, was especially curious coming as it did during President-elect Bush's economic summit. The move gave all the appearances of sending a message to the new Administration that monetary policy is a more flexible tool for managing the short-term ups and downs in the economy than fiscal policy.
The intermeeting cut also indicated an urgency that plainly shows that the Fed is more concerned about the health of the economy than any Fed-watcher had thought only a few days earlier (charts). What may have shocked the Fed to move was the striking weakness of the Jan. 2 report from the nation's purchasing managers.
The Purchasing Managers' index--a composite of production, orders, employment, inventories, and delivery times--fell to 43.7% in December, from 47.7% in November. It has been below 50% for five months now. That's the break-even point between growth and recession in the industrial sector. Before December, the index had been in the 46%-50% range associated with the soft landing of 1994-95. But last month's reading crashed through that floor, and now stands at its lowest point since the 1990-91 recession.
Although the PMI only covers manufacturing, which makes up only about 16% of the economy, the recent plunge deserves special attention. That's because, unlike the 1998 falloff in industrial activity triggered by the Asian crisis, this factory slump cannot be traced to any external factors: This weakness is all homegrown, thanks to the stock-market sell-off and past interest-rate hikes by the Fed.
In coming months, economists and policymakers will watch the PMI--long known to be a favorite of Fed Chairman Alan Greenspan--to see if it sinks below 42.4%. Based on historical patterns, that's the reading associated with an economywide recession. But the report offered no encouragement for the future. New orders and the backlog of unfilled orders contracted at a faster pace in December than in the previous month.
FOR NOW AT LEAST, the manufacturing weakness is decidedly low-tech and concentrated in the auto and related industries, as a result of excessive car inventories. Through November, factory production was up 4.6% from a year ago, but excluding computers, peripherals, electronic components, and communications equipment, factory output is down 0.2% from last year. High-tech output has also slowed, but from its supercharged pace of earlier this year. The Fed's Jan. 2 statement noted that "there is little evidence that the long-term advances in technology and associated gains in productivity are abating."
However, the purchasers' survey suggested that the excess factory inventory goes beyond cars. The December percentage of companies reporting that the inventory levels of their customers were "too high" rose further, continuing its climb since July. Indeed, government data show that the ratio of inventories to sales in the factory sector has been rising since the middle of 2000.
THE MANUFACTURING DOWNTURN is having a direct effect on other key economic indicators. For example, a good deal of the recent rise in initial unemployment claims reflects factory-sector layoffs, especially in the auto industry. Moreover, initial claims are one of the 10 components of the Conference Board's index of leading indicators. Claims and four other factory-related indicators--the factory workweek, orders for both consumer and capital goods, and the purchasing managers' measure of delivery times--make up half the index.
It's little wonder, then, that the leading index has been so weak. It fell for the second month in a row in November, down 0.2% from October, when it dipped 0.3%. The index, which also reflects the slide in stock prices, has been in a downtrend through most of 2000. The composite indicator has not yet fallen enough to give a clear sign of an impending recession, but based on its historical performance that point is not far away.
Manufacturing's woes may also be playing a big role in the recent slip in consumer confidence, which the Fed listed as one of the reasons for its move. Layoff announcements at well-known companies such as Ford Motor Co. and American Standard Cos. resonate more among Americans than failures of short-lived dot-coms.
The Conference Board's index of consumer confidence fell to 128.3 in December from 132.6 (chart). The index covering expectations for the economy fell steeply, to 95.8 from 101.2. The board said the drop was "disconcerting" and if expectations continue to decline, "a more severe economic slowdown may be on the horizon," since worried consumers may choose to delay purchases.
That's just the kind of vicious cycle that the Fed's rate cut was aimed at avoiding. The Fed has begun 2001 with a clear sign that it stands at the ready to ensure that the rest of the economy does not follow manufacturing into a recession.