U.S.: This Recovery Insurance Is Low Risk--and Low Cost

With inflation tame, it's safer to cut rates too much than too little

The Federal Reserve took out some recovery insurance on Aug. 21 when it cut interest rates for the seventh time this year. And why not? The price was too cheap to pass up.

Despite some signs that the worst is over, the economy's first-half weakness has seeped into the third quarter. The frailty makes for a mixed bag of data. Output cuts by tech producers are getting larger, but losses at old-line manufacturers are narrowing. The index of leading indicators, those that foreshadow the economy's path, has now risen for four months in a row, while retail sales and housing continue to hold up surprisingly well (charts). But consumers aren't spending as vigorously as they did in 1999 and 2000, and exports are losing more ground.

Against that backdrop, the Fed trimmed another quarter-point off its overnight federal funds rate, to 3.5%, and said it remains concerned that the risks in the outlook are tilted toward economic weakness. The stock markets were hoping for a more optimistic tone from policymakers. The only bright note in the announcement was that "household demand has been sustained." Back on June 27, when the Fed last cut rates, consumer spending was characterized as "weak." Without any assurance that the end of the tunnel was in sight, investors pushed the Dow Jones industrial average down 146 points on Aug. 21, and the Nasdaq was off 50 points.

The Fed's caution means another cut at the Oct. 2 meeting cannot be ruled out, and upcoming data, especially on employment, capital-goods orders, and the purchasing managers' survey will be key in determining the Fed's next move. Luckily, policymakers can afford to err on the side of accommodation because falling prices for energy and tech gear are keeping inflation tame.

JULY CONSUMER PRICES made that point loudly. Thanks to a 5.6% plunge in energy prices, the consumer price index fell 0.3% from June. Replicating a global trend, the yearly inflation rate, which had been held up by costlier gasoline and natural gas since early 2000, fell from 3.2% in June to 2.7% in July, the lowest rate since January, 2000. Some further decline in energy prices is likely in August as well.

The core CPI, which excludes energy and food, rose a modest 0.2% from June to July, even though tobacco prices jumped 4.8%. Excluding that surge, which relates more to legal than market influences, the core CPI increased a scant 0.1%, and yearly core inflation is 2.7%--about where it has been all year.

In addition, the Fed's preferred measure of inflation, the price deflator for consumer spending, looks even more favorable. Through June, core inflation using that price gauge was 1.8%, nearly a percentage point lower than the core CPI, and the rate is down slightly over the past year. The dissimilarities in the indexes partly reflect different treatment of housing and medical care, which have been adding to CPI inflation over the past year.

Lower inflation, especially in the energy and technology sectors, figures prominently in the recovery outlook as well as for policy. For businesses, lower fuel costs and cheaper productivity-building machinery hold down expenses and boost profits. For consumers, low inflation increases purchasing power at a time when nearly 64% of the population is employed, one of the highest levels in the postwar era. For June and July, real weekly earnings of production workers scored the largest two-month gain in almost four years.

STURDY INCOME GAINS are a big reason why consumers continue to lift their spending at a rate that will keep the economy afloat. The pace of shopping at the beginning of the third quarter about matched that of the second quarter. Retail sales in July were unchanged from June, and excluding lower auto sales they rose 0.2%. However, the month's 11% dive in gasoline prices pushed receipts at gas stations down by a record 4.2%.

The sales drop at the gas pump concealed strong increases at other stores, including those that sell electronics, clothing, health products, and general merchandise, as well as at restaurants. The July strength means consumer spending, as it is counted in the gross domestic product data, is off to a solid start this quarter. Real outlays may be growing at an annual rate slightly faster than the second quarter's 2.1% pace.

The July sales gains were in areas that would be expected to be affected by tax-rebate spending. Still, only a small portion of those checks hit consumers' mailboxes that month, suggesting the boost to August sales will be even greater. Also, since the Commerce Dept. bases its preliminary monthly data on an incomplete survey, July sales could be revised upward.

Consumers will continue to spend as long as they are confident about the future. That's why the pickup in consumer sentiment in early August, according to the University of Michigan's survey, is a good omen for the outlook. And perhaps a more telling measure of confidence is consumers' willingness to commit their future resources to buy a new home. Housing starts rose 2.8% in July to the highest level since January, 2000. Moreover, builders are increasingly upbeat. In August, the housing market index compiled by the National Association of Home Builders jumped to 62, from 56 in July--as high as it has been since November.

ONE AREA THE FED has a close eye on is manufacturing. That's where the economy's troubles began last year, and the Fed will require some concrete signs of improvement there--for both production and profits--before it can stop its rate-cutting regimen.

On that front, the July data on industrial activity offered both hope and gloom. Overall industrial production fell 0.1%, and manufacturing output alone was flat from June. But outside of technology industries, manufacturing output rose 0.2%, buoyed by a 4.7% jump in auto output. It was the first such increase since last September. Tech-sector production, however, plunged 2.4%, the largest drop of the year (chart).

The firmer tone of production outside of tech suggests that the deepest part of the inventory reductions are now past. If so, it will provide a lift for production and economic growth in the coming months. Stock levels of manufacturers, wholesalers, and retailers fell 0.4% in June, the fifth monthly decline in a row. The problem: The ratio of inventories to sales for tech-equipment manufacturers is still rising, suggesting that stockpiles in the tech sector are still way out of line with demand.

The tech sector will continue to hold back manufacturing activity for some time to come. With the economy still facing dangers, the Fed may not be finished cutting rates. And with the inflation outlook improving, the risk of overeasing is one that policymakers can afford to take. Policymakers would prefer to cut rates once too much rather than risk an end to the expansion.

By James C. Cooper & Kathleen Madigan

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