Commentary: If the Worst Is Over, Why Is the Fed So Tense?

By Rich Miller

What downturn? Check out the financial markets in the last month, and everything seems finally to be coming up roses: The economy has weathered the worst and is ready to rebound. Despite some profit-taking on May 23, that's what investors seem to be betting. Stock prices have soared on hopes of fatter corporate profits later this year. After being battered to near bargain basement levels, the Nasdaq composite index has climbed more than 15% in the last five weeks. Bond yields have risen on expectations that improved consumer confidence will boost economic growth and lead to higher interest rates. The yield on the 10-year Treasury is up to 5.39%, vs. 5.20% a month ago. Even commodity prices are higher in anticipation of stronger demand from a revived economy. Gold is up more than $20 an ounce since April 17.

Wall Street's exuberance, though, isn't shared by the Federal Reserve. Fed Chairman Alan Greenspan & Co. are a long way from breaking out the champagne glasses to toast themselves for another job well done. They're too busy grappling with a series of New Economy problems that could yet tip the U.S. into recession or leave it saddled with meager growth for months to come.

NEWFANGLED FEARS. At the top of the Fed's worries: pinched corporate profit margins. In the Old Economy, these were less of a problem. Companies often were able to raise prices to recoup higher costs. But in the New Economy of cutthroat competition, that's just not possible. Faced with a squeeze on earnings, companies continue to slash capital spending and pare payrolls, threatening to turn the slowdown into an outright slump.

Unfortunately, there's no end in sight to the erosion in corporate profits. According to data compiled by Thomson Financial equity strategist Joseph S. Kalinowski, Wall Street analysts continue to cut their earnings forecasts for the companies they follow. The numbers, which get passed on to the Fed and Greenspan, show that analysts on average expect operating earnings of companies in the Standard & Poor's 500-stock index to fall 12% in the second quarter after dropping by 6.5% in the first. One glimmer of hope: The pace of the decline in the consensus forecast has slowed of late. Despite some recent jitters, investors have been looking past the ugly earnings reports due out this quarter to a hoped-for upturn later this year.

Capital-spending cutbacks are the second New Economy problem facing Greenspan and his fellow Fed policymakers. An investment boom in the late 1990s led to a surfeit of capacity and now threatens to give way to a capital-spending bust. The problem has been most acute among high-tech companies, which boosted capacity an astounding 48% last year. To try to bring things back into line, they're expected to slash capital outlays by 18% this year, according to Fed estimates. Semiconductor companies, which at the end of last year projected a 15% rise in their investment spending in 2001, now plan for a 25% cut.

The last New Economy issue confronting the Fed is the negative wealth effect. In the go-go years of the late 1990s, the ever-rising stock market fueled growth by boosting the paper profits of a growing legion of individual investors. The slump in the stock market since then is threatening to do the opposite and pull the economy down. Despite its recent rally, the Wilshire 5000 Total Market index is down nearly 20% from its high in March, 2000. In fact, Fed officials have been pleasantly surprised that the combination of the market slide and rising unemployment have not taken a bigger bite out of consumer spending. Fed insiders say Greenspan believes that the destruction of stock market wealth has been partly offset by still rising property prices, which have boosted homeowners' equity. Some question how long that can last.

Just like the high-tech CEOs who got caught in the downdraft, top Fed policymakers have no crystal ball to show them where the economy is heading. They're just hoping that five rapid-fire interest-rate cuts this year will set the stage for an economic revival. But faced with a New Economy slowdown, they're not so sure it will--no matter what the financial markets might be saying.

Miller covers the Federal Reserve from Washington.

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