The Big Easing
By Michael Englund
Federal Reserve policymakers today will face the same decision as at their Oct. 2 meeting -- whether to cut the key Federal funds target rate by 25 or 50 basis points. Standard & Poor's MMS expects the Fed to make the same choice this time around, and opt for a jumbo 50 basis point easing, with a further bias toward addidtional rate cuts.
With rates already at their lowest point in decades, the reasons to reduce the pace of easing to smaller 25 basis point steps are greater now than before. But we suspect that the weakness in recent reports on factory orders, consumer confidence, and the sharp drop in October nonfarm payrolls will provide plenty of reasons. The biggest caveats will be the already-low level of the Fed funds rate, an improved tone in the stock market, and the spurt in vehicle sales in November, which may suggest that the consumer pull-back beyond September will prove smaller than feared.
Prices of Fed funds futures, a trading vehicle used by market pros to place bets on the direction of Fed policy, are biased slightly in the direction of S&P's forecast. The November contract indicates a 55% likelihood of a 50 basis point easing, vs. a 45% likelihood of a smaller 25 basis point move. Beyond the Nov. 6 meeting, the market is implying a 1.98% Fed funds rate for December, assuming a total easing of 52 basis points by December. The implied rate then falls to 1.84% in February, March and April, which suggests a cumulative 66 basis points of easing left in this cycle.
Beyond Nov. 6, S&P's forecasts largely agree with the market consensus, as we are not expecting any further cuts in the Fed funds rate target beyond 2% -- but we do see the risks as biased toward one more 25 basis point easing in December or January.
The employment, factory orders, NAPM, and consumer confidence reports for October have certainly given Fed Chairman Alan Greenspan all the ammunition he needs to convince the policy committee's "hawks" -- who continue to view controlling inflation as the Fed's top priority -- to support a 50 basis point move if that is his preference. These reports indicate that uncertainty is sharply impacting the factory sector, and is having a big impact on consumer perceptions and employment regardless of the pattern likely to unfold in actual household spending.
The weakness in these numbers suggests that the economy may stand to benefit from the psychological impact of a large Fed easing on household behavior, even if it proves necessary to quickly reverse this "extra" easing early in 2002 if the move proves excessive. We've seen this from Greenspan before. The Fed chief is predisposed toward steering market and household behavior with Fed "announcement effects." Case in point: the Fed's aggressive moves in 1998 following the global financial market collapse. We at S&P expect this policy path to continue.
In our view, the greatest market risk is that the Fed will be done easing after the Nov. 6 move, despite the likelihood that it will say it remains biased toward more easing in its post-meeting statement. This may prove modestly damaging to the markets as the Dec. 11 FOMC meeting approaches.
The reason? Heightened interest rate sensitivity on the part of the consumer. Take a look at the explosive rise in auto sales for October, which has ruled out the worst-case scenario for post-September 11 household spending. Vehicle sales reached 21.1 million units in the month, a whopping 34% surge from September's 15.8 million units. It appears that rebate checks saved in September were quickly deployed in October, and that households were highly receptive to the low interest rates seen in the form of zero percent financing.
We have yet to see whether tax cuts and a high level of interest sensitivity were factors for other forms of spending as well, so the October retail sales report, scheduled for release Nov. 14, should prove crucial. These data, along with other key reports, will determine whether the Fed will be pushed into a wait-and-see mode.
Englund is chief market economist for Standard & Poor's