U.S.: That Makes Four for the Fed. Don't Count Out a Fifth

If the labor and stock markets don't cooperate, expect a May cut, too

In the end, eight weeks was just too long a time to wait. And on Apr. 18, the Federal Reserve once again shocked the financial markets by cutting interest rates between its regularly scheduled meetings.

The cut of a half-point was the fourth rate reduction this year and brought the target for the federal funds rate down to 4.5% (chart). In its statement, the Fed raised three serious concerns about the economy going forward: Eroding profits expectations may dampen capital spending, the reverse wealth effect from falling equity prices might weaken consumer spending, and growth abroad might slow further. According to the Fed, those uncertainties "threaten to keep the pace of economic activity unacceptably weak."

That phrasing is important. The Fed seems to be saying it is not as worried about an imminent recession as it is about growth being so feeble that rising layoffs and cuts in capital budgets could trigger a downturn later on. The economy probably grew at less than a 1% annual rate last quarter, about the same puny pace posted in the fourth quarter.

The rate cut continues the policy of extreme aggressiveness in the face of extreme economic uncertainty. Fed Chairman Alan Greenspan can act forcefully because inflation is still not a threat to the expansion. Instead, policymakers kept their policy bias weighted toward fears of future economic weakness. That means the latest move does not rule out another rate reduction at the May 15 meeting.

Moreover, the timing enabled the Fed to ease policy into an upturn in the financial markets. Sentiment among equity investors seemed to have brightened in the days before the cut. So the Fed action was not fighting pessimism on Wall Street. Predictably, stock prices soared on the news.

WHAT TURNED THE TIDE for policymakers? The latest data clearly raise risks for both capital investment and consumer spending. Falling business sentiment and continued warnings about profit shortfalls suggest that capital spending will remain weak. Yet at the same time, rising jobless claims and falling household sentiment put new downside risks on the crucial consumer sector.

The Fed did point out some pluses for the economy. Most importantly, the inventory correction seems "well advanced," and it's this inventory adjustment begun last fall that is causing the current sluggishness, including the manufacturing recession.

In the first quarter, however, businesses made great headway in adjusting their stockpiles. Inventories at factories, wholesalers, and retailers rose just 0.1% in January and then fell 0.2% in February. But the progress was uneven. Car dealers were especially proficient at clearing out their lots: Retail inventories of motor vehicles fell 0.2% in January and then plunged 1.5% in February (chart).

With inventories back to normal, Detroit has ramped up production. Total industrial production in March posted an unexpected gain of 0.4% after dropping for five months in a row. Factory output rose 0.3%, but almost all of the increase came from a 7% jump in the auto sector. Excluding that, output fell 0.1%.

For the first quarter as a whole, factory production fell at an annual rate of 5.6%, the biggest decline since the 1990-91 recession. Auto output alone plunged by 31.5%. But for the second quarter, auto makers are planning to keep increasing production. That will lift overall industrial activity and boost auto payrolls.

UNFORTUNATELY, makers of high-tech equipment will not have such an easy time this spring, and that's a major worry for the Fed. The New Economy industries were not as adept as old-line companies at managing their inventories. Starting last September, manufacturers of computers, semiconductors, peripherals, and telecom equipment kept adding to stockpiles even as sales and orders were slipping. That error now puts the inventory problem squarely in the New Economy's corner. And keep in mind that Greenspan has placed his faith in the New Economy as the source for productivity growth which will keep inflation low.

In hindsight, it's clear that tech makers--and perhaps the Fed--got caught by the surprisingly quick falloff in business spending for equipment. Investment in capital goods slipped at a 3.3% annual rate in the fourth quarter and likely fell at close to a double-digit pace last quarter. If so, the drop would be the largest since the last recession.

As the Fed stated, the risk to the outlook is that capital spending may not turn around soon. After all, businesses have plenty of reasons to cut back. Declining profit growth means companies are not generating the money for investment, and tighter bank-lending standards and the weak stock market mean they cannot raise the cash elsewhere. The tech sector is already awash in extra capacity, so new investments there make little sense. Finally, businesses have little reason to add to capacity when demand is soft.

POLICYMAKERS MAY FEAR that a capital-spending slump may snowball and drag down consumer spending as well. But for now, the Fed said, "consumption and housing have held up reasonably well, though activity in these areas has flattened recently." In fact, real consumer spending probably grew at a solid 3% or so annual rate last quarter. And homebuilding remained pretty healthy.

But the strength of both retail sales and housing was concentrated early in the first quarter. In March, retail sales dipped by 0.2%, and housing starts fell 1.3%, to an annual rate of 1.61 million.

The weak March data mean these two sectors began the second quarter at a low level relative to the first, but there is no sign that consumers have thrown in the towel completely. First, bad weather may have dampened the March data. Second, weekly sales surveys show store sales were rising in the first two weeks of April, while mortgage applications to buy homes were still at a high level at mid-month.

The Fed cited earlier reductions in equity wealth as a concern, but what could truly throw a monkey wrench into the consumer outlook is the labor market. The slowdown in employment growth, coupled with the wave of layoff announcements, could trigger job jitters among consumers, who would then start saving more instead of spending more. In early April, jobless claims had risen to above 380,000 (chart). That's getting close to the 400,000 range associated with a recession.

You can be sure that the Fed will be watching the labor market--as well as the stock market--closely. If either causes domestic demand to slow too rapidly, the Fed will step in quickly with more rate cuts. Rest assured, the April surprise was policymakers' way of saying: We're not done yet.

By James C. Cooper & Kathleen Madigan

    Before it's here, it's on the Bloomberg Terminal.