U.S.: The Fed's Summer Vacation Could Last Through Autumn

New uncertainties may keep interest rates on hold for a long while

Policymakers at the Federal Reserve will sit down on June 25 and 26 to hammer out their view of the economy's future and how that outlook will determine monetary policy. Expectations are that the Fed will hold short-term interest rates steady at its June meeting. But more important, chances are growing that the central bank could stay on the sidelines until yearend.

That was hardly the sentiment in the financial markets just a few months ago. By late March, investors had bid up the contract rate for federal funds futures scheduled to settle in December, 2002, to 3.4%. In other words, investors were betting that, by yearend, the Fed would push the target rate for fed funds to nearly twice its current 1.75% level.

But now, the December futures rate is down to only 2.3% (chart). That works out to just two quarter-point hikes during the Fed's five remaining meetings in 2002. Most economists now see the first increase in September, and a few think the Fed will not hike until 2003. The change of heart seems to dismiss the economy's stellar performance. Broadly upbeat second-quarter data are following on the heels of a 5.6% surge in real gross domestic product in the first quarter. That winter surge was one reason behind the earlier expectations for Fed tightening.

Other factors, however, are now coming into play, and they could well stay the Fed's hand for a long while. In particular, recent comments by Fed officials, including Chairman Alan Greenspan, show they have little if any inclination to move policy away from its current, very stimulative stance.

POLICYMAKERS will certainly make their decisions with one eye on the current corporate upheavals and the fallout on stock prices. Policy decisions also will be affected by lackluster labor markets and even the timing of government economic reports. Plus, the Fed will place heavy emphasis on prospects for capital spending and the lack of price pressures in setting rates, not to mention the ongoing threat of terrorism.

Questions about corporate governance and accounting practices have both shaken and angered investors. The growing lack of confidence in earnings reports, as well as criminal indictments, have roiled the stock markets, even as the prospects for economic growth and profits have brightened. Newly appointed Fed Governor Susan S. Bies has spoken twice on corporate governance, while San Francisco Fed President Robert T. Parry said uncertainty about profits has been "accentuated by concerns about corporate accounting practices."

Policymakers recognize that these Enron-triggered equity woes have little to do with what is going on in the real economy. Other areas of the financial markets are waking up to the brighter outlook. For example, while the stock market frets over corporate balance sheets, the bond market sees fewer dangers. The spread between moderately risky corporate bonds and riskless Treasury bonds has narrowed significantly since the beginning of the year. That means bond investors see less of a credit risk among corporations (chart), and companies are tapping the bond market to raise funds to finance business activity.

Also, fewer banks are tightening their lending standards, making more money available. The yearlong slide in bank loans to commercial and industrial businesses shows signs of bottoming out in recent weeks.

HOWEVER, THE GROWING DISTRUST of Corporate America is dragging down the stock market, an issue that could well hamper the recovery and complicate future policy. The drop in equity prices is a de facto tightening of financial conditions, making it harder to raise funds for capital projects, hire people, and finance new products. The Fed will offset this market restraint by maintaining its own accommodative stance.

Worries about the recovery won't go away anytime soon. The latest May reports on retailing, car sales, and payrolls suggest real GDP growth in the second quarter is far slower than its first-quarter gallop. Even Greenspan noted on June 4 that "we're going through a soft spot right now." A slow spring, to a great extent, will reflect payback for the first quarter's exaggerated strength, some of which was "borrowed" from the second quarter as a result of unusually mild weather.

Nevertheless, the first read on second-quarter GDP will not come out until July 31, soon before the Fed's Aug. 13 meeting. If real GDP is growing at around a 2% annual rate this quarter, the Fed will have another reason to hold rates steady through the summer or even into autumn as it scours the monthly data to determine what the pause may mean for second-half growth. All the while, inflation, which is already low and tends to decline in the first year of a recovery, will give the Fed plenty of leeway to keep rates low.

MOST IMPORTANTLY, the Fed will focus on the monthly employment reports to gauge the state of the labor markets. Historically, the Fed does not start to lift interest rates until the unemployment rate has begun a sustained downtrend.

Does the May drop in the unemployment rate to 5.8% from 6% in April indicate that rate hikes are on the way? Hardly. Overall, the May job report was uneven, and job growth is far from the gains of greater than 150,000 per month needed to send the jobless rate on a lasting downward slope. The Fed will prefer to wait for more concrete signs of a firmer labor market before it adjusts its policy stance.

According to the May employment report, private payrolls rose by a small 27,000 last month, after a revised 18,000 increase in April (chart). Hiring at temp agencies led the job gains, while manufacturers continued to lay off workers and construction employment held virtually steady, as did the overall workweek. On the plus side, factory overtime edged up by six minutes in May, and 50.6% of industries added workers last month, the highest rate in 17 months. More overtime and broadening job gains typically presage more hiring.

Consumers may have to get used to a mixed bag of job reports. As long as businesses can use productivity gains--instead of hiring workers--to boost output, the labor markets won't tighten much. The plus side to productivity is that most workers are still receiving pay raises that are above the inflation rate. In May, the yearly growth rate in the average hourly wage for production workers was 3.2%, down a full percentage point from May, 2001. However, real pay grew 2.1%, up from 1.8% this time last year.

Productivity trends will be only one factor that policymakers take into account when they sit down to map out their expectations for the economy. It's a sure bet that the Fed will take no action in June and a good bet they will remain idle in August. And unless economic circumstances change significantly, policymakers could even extend their summer vacation through the rest of the year.

By James C. Cooper & Kathleen Madigan

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