For the Fed, the Stakes Are Rising

The ugly August jobs report ups the odds of either a half-point rate cut at the Oct. 2 Fed meeting -- or an even earlier quarter-point easing

By Kim Rupert

The "R" word -- recession -- intruded on investors' consciousness with a vengeance on Friday, Sept. 7. The employment report for August released that day showed a jump in the unemployment rate to 4.9% -- an exclamation point to those who thought the "pink slip" parties were largely confined the high-tech sector. Though the storyline for the U.S. economy of a data dichotomy -- contraction for the factory sector and slow to no growth for other areas -- remains intact, the general growth trajectory has now been lowered by gloomy reports on inventory and the health of manufacturing.

And this lower trajectory may leave gross domestic product growth in negative territory in both the second (as revised) and third quarters -- fulfilling the conventional definition of a recession. The data practically guarantee at least a quarter point cut by the Oct. 2 meeting of the Federal Open Market Committee, the Fed's rate-setting arm -- and raise the probability of either a between-meeting cut or a 50 basis point easing at the meeting.

With a recession a clear and present danger, the results from the weekly Standard & Poor's MMS survey of Fed watchers show nearly unanimous expectations for another rate cut (97% of respondents) by the Oct. 2 FOMC meeting, and reflect significantly increased likelihood that the Fed cuts the Fed funds target rate to 3.0%, if not 2.75% by year-end or in early 2002.

RISING ODDS.

  Not surprisingly, the gloom in Friday's data also heightened talk that the FOMC might cut rates prior to the upcoming meeting, or else might revert back to an aggressive 50 basis point reduction at the Oct. 2 meeting. And for the first time in the MMS Survey, the median expectation for the Fed funds target rate for the Nov. 6 FOMC meeting is now at 3.0%. While the median figure for the Dec. 11 FOMC gathering is at 3.0%, nearly 19% of our contacts believe the rate will be down to 2.75% by year-end. Many of those who project a 3.0% year-end target look for the Fed to lower rates to 2.75% early in 2002.

Clearly the Fed will be worried by the recent string of data releases indicating a more severe and longer-lasting erosion in economic conditions than previously anticipated. While the FOMC hawks -- the members most watchful of inflation -- may have had the floor through the spring and early summer, expectations for a quick recovery thanks to policy easing and tax cuts have been shattered. The steep sell-off in equities, the recent drop in consumer confidence, and the heat the Fed will feel from the weekend press will raise the likelihood that the doves, who regard promoting growth as more important than controlling inflation, retake the helm and instigate an intermeeting easing. And early this week offers a good possibility for a move.

One interesting thing to note: The two times the FOMC has eased policy outside of a meeting have come around the mid-point between FOMC meetings -- which occurs during the coming week. A rate cut early in the Sept. 14 week also avoids signs of a panic move by Greenspan & Co.

A LOOK AHEAD.

  Many Fed watchers contacted by MMS thought a between-meeting 25 basis point rate cut and an additional 25 basis point easing at the October meeting offered the better scenario, rather than Greenspan & Co. waiting another four weeks and cutting by 50 basis points. This environment is ripe for rumors or leaks regarding the current thinking and possible intentions of policy makers in the days and weeks ahead.

There is little in the way of compelling data reports or events on the economic docket early in the week. This leaves both the bond and stock markets plenty of time to ponder the August payroll report and its implications and repercussions. Traders won't have to think too hard, though. With the increased likelihood that the economy has indeed fallen into recession, Treasuries remain the place to park cash, especially with the Fed needing to take rates lower.

Rupert is a senior economist for Standard & Poor's Global Markets