U.S.: Patience, Investors. The Fed Is Not Done

But economic data, not the stock market, will dictate policy

At nine yards long, the Federal Reserve's oval table is too big for poker. But on Mar. 20, policymakers entered into a high-stakes game. The pot: an economic rebound in the second half.

At its second policy meeting of 2001, the Fed lowered its benchmark federal funds rate by a half-point, to 5%, eschewing Wall Street's clamor for a supersize cut of three-quarters of a point. The move followed half-point reductions on Jan. 3 and Jan. 31. In effect, the Fed made it clear that it will not follow the stock market's timetable for policy decisions. The Fed's action implicitly says that economic conditions did not justify a larger, more radical move.

Investors were greatly disappointed by the size of the cut, even though the Fed has not targeted a one-time cut of 75 basis points since it began pegging the federal funds rate in 1983. Stocks sold off sharply and broadly for the day, extending the dizzying decline in equity values in recent weeks.

But therein lies the Fed's gamble. The market and economic growth have become increasingly interdependent, through both confidence in the future and the wealth effect. The market's failure to turn around could put a second-half rebound in the economy in jeopardy.

Shoring up investor sentiment will not be easy. Investors were so focused on the idea that "size matters" that they completely ignored the meeting's most obvious positive: The Fed left open the door for more cuts--perhaps even before its next meeting on May 15.

The Fed's statement noted the "rapid response" of manufacturing output to excess inventories, and that spending had "firmed a bit." However, in a hint of more rate cuts to come, the Fed pointed to the possibility of continued excess production capacity and the potential for weakness in global economic conditions, which suggest "substantial risks" that demand and production could remain soft.

BUT THE KEY REMARK WAS: "In these circumstances, when economic conditions could be evolving rapidly, the Federal Reserve will need to monitor developments closely." That language should sound familiar. It is similar to what the Fed said after its Dec. 19 meeting, prior to the surprise intermeeting cut on Jan. 3. It's Fedspeak for: "We may not wait until May 15."

Three reasons explain why an intermeeting cut is not out of the question. First, and most important, low inflation gives the Fed an unprecedented amount of leeway to cut interest rates. Second, the time between scheduled meetings is an unusually long eight weeks.

And finally, the latest economic data is at best mixed (charts). The manufacturing downturn is worsening, inventories are top-heavy, and consumer confidence has shown scant improvement. But jobs and retail sales are growing faster now than they did at yearend. Home demand and construction are firm, while auto sales have rebounded.

But right now, investors are turning a blind eye to any bit of good economic news. They also are ignoring the Fed's aggressive efforts to stimulate demand. The Fed's self-described "rapid and forceful" action since Jan. 3 is unprecedented for the Greenspan Fed, which has never cut rates by 150 basis points in the short period of only 2 1/2 months--not even during the 1990-91 recession.

And keep in mind that these cuts reverse all but a quarter-point of the Fed's 1999-2000 policy tightening. Those rate hikes totaling 175 basis points were the genesis of the sharp slowdown in demand that has sent profit expectations tumbling, inventories soaring, and manufacturing output dropping. But today's slowdown follows a fairy-tale growth rate of 5%-6%, which many businesses, consumers, and investors came to accept as a new reality.

ADJUSTING TO A SLOWER PACE has been especially jarring for investors because it requires a significant shift in short-term profit expectations and thus a revaluation of stock prices. This adjustment is a key factor behind the slump in consumer and business confidence. But the Fed seems to believe that sentiment--and stock prices--will recover as the Fed's latest easing works its magic on the economy in the second half.

That act of faith, however, is risky if falling stock prices cream confidence and cut into demand before lower interest rates come to the rescue of the economy. The Fed is counting on cheaper financing costs to enable more consumers and businesses to buy big-ticket items ranging from cars to computers to office machinery. Healthier demand will clear out the inventory overhang that dragged the factory sector into recession in late 2000, and it will put a floor under cutbacks in capital spending and eroding profit expectations.

The factory slump continued into the first quarter, and very likely will extend into the second. Industrial output fell 0.6% in January and February, the biggest back-to-back declines since the 1990-91 economywide recession. Manufacturing output alone fell 0.6% in January and another 0.4% in February.

BUSINESSES ARE STILL CUTTING their stockpiles to levels more in line with demand. The Fed noted that the adjustment "appears to be well underway," but more work is needed, especially in the high-tech sector. Over the past six months, the growth in output of computers, semiconductors, peripherals, and telecom equipment has slowed to an annual rate of 19% from a red-hot 64% pace in the previous six months. This slowdown is what triggered the fall in profit expectations for tech companies, hammering their stock prices.

U.S. manufacturers, high-tech and otherwise, aren't the only ones grappling with cooler demand and the ongoing inventory adjustment. Foreign producers are also getting hit as U.S. businesses cut back on orders. The good news is that slower import growth is stemming the deterioration of the trade deficit. The trade gap widened slightly to $33.3 billion in January, from $33.2 billion in December. The January level was little different from the fourth-quarter average, suggesting that foreign trade may not have subtracted much from real GDP growth in the first quarter.

One area that improved sharply was the trade deficit in high-tech goods, reflecting a steep drop in import growth (chart). The turnaround supports the idea that foreign producers are sharing the burden of cutting U.S. inventories as companies pare down their stock levels.

For now, such an adjustment seems likely to be short-lived, especially since the Fed has served notice that it stands ready to support economic growth. And judging by its cut on Mar. 20, the Fed will make policy decisions based on economic conditions, not stock-market performance. That has long been the Fed's strategy, but this time around, trying to ignore Wall Street may be a risky wager. The Fed needs a stable stock market to achieve its goals for the economy.

By James C. Cooper & Kathleen Madigan

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