U.S.: The Fed May Be Getting an Itchy Trigger Finger

But amid uncertainty and global woes, a rate cut might not help much

In a sudden turn of market sentiment, expectations of a cut in interest rates by the Federal Reserve before yearend have risen sharply in recent days. The action could come as early as the policymakers' Nov. 6 meeting, given the current downdraft in economic activity that hit in late summer and early autumn.

Based on futures contracts for the federal funds rate--the Fed's policy tool--market players are now betting that the chances of a quarter-point cut at the Nov. 6 meeting are about three out of four, and that a cut of that size by yearend is all but certain. Some analysts even project a half-point reduction.

The Fed has been waiting for past rate cuts to kick this recovery into high gear. But several factors suggest that their patience is wearing thin. First, the Fed has been poised for action since August, when it changed its view of the outlook to highlight the risks of economic weakness. Second, recent data evince those concerns: Third-quarter economic growth, while solid, was front-loaded, with production, sales, and orders losing ground as the quarter progressed. And as the fourth quarter began, October consumer confidence fell to a nine-year low (chart).

Third, two policymakers voted against the Sept. 24 decision to keep the fed funds rate at 1.75%, preferring instead an immediate rate cut. One of the dissenters was Governor Edward M. Gramlich, and Fed governors normally do not oppose the position of Chairman Alan Greenspan. With the economy looking worse now than at that meeting, the dissenters have gained credibility, and sentiment for a rate cut is almost surely broader.

Finally, a rate cut would be easily justifiable as low-cost recovery insurance. Exceptionally strong productivity growth and stiff global competition, along with the normal lagged effects of a recession, assure that inflation will stay down in 2003, if not slow further. That gives the Fed plenty of time to reverse any additional stimulus should economic growth rocket up next year.

AS IS USUALLY THE CASE, the Fed will examine the data before setting policy. But with uncertainty running unusually high, the Fed will place more weight on indicators of real activity--orders, sales, and output--than on gauges of sentiment that reflect economic angst more than economic reality. Crucially, the Fed will have to decide if the current slowdown is a temporary period of softness caused by corporate hesitation after the summer's new uncertainties. Or is it the start of renewed stagnation or outright recession?

To be sure, businesses have pulled back (chart). Industrial production fell in August and September, inventories were cut further in August, and the trickle of hiring earlier in the summer came to a halt in September. The 5.9% plunge in September durable goods orders also fueled concerns of further layoffs. Plus, orders for capital goods, excluding the volatile defense and commercial aircraft sectors, fell 6.6%, suggesting new weakness in capital spending (chart). But as long as overall demand keeps growing even modestly, chances are high that businesses will become confident enough to gear up again by yearend and into 2003.

THAT'S WHY THE OCTOBER PLUNGE in both major gauges of consumer confidence to 1993 levels raises the ante for the Fed to act soon. Consumers have been the economy's driving force this year. With businesses already freezing up, if the plunge in confidence indicates consumers are throwing in the towel as well, then it could be a tough winter for the economy.

After the University of Michigan's sentiment index fell, the Conference Board's index slid 14.3 points in October, to 79.4, undoubtedly reflecting fears over the job markets, Wall Street, Iraq, and maybe even a dollop of national angst over the sniper shootings.

The steepness of the October drop is worrisome, but whether it translates into an outright retrenchment in spending remains to be seen. Remember that, from its September 11 plunge until May, 2002, the confidence index rebounded by 25 points. Since then, news of corporate scandals, the stock market slide, and fresh war worries pulled the index down by 30 points. Even so, consumers kept spending, and labor market conditions were fairly stable.

Indeed, housing demand has not suffered, despite the sag in confidence for the future, which home buyers must have before making such a major financial commitment. Sales on both new and existing homes rose in September, with new-home demand at a record annual rate of 1.02 million. However, through mid-October, mortgage applications to buy a home were trending downward, and so the upside potential for housing to drive economic growth in coming quarters is waning.

ONE OF THE MOST POSITIVE IMPACTS of further rate-cutting by the Fed would be its resonance around the world. In particular, a U.S. cut would put pressure on the European Central Bank to ease policy. Growth in the euro zone has almost ground to a halt in the fourth quarter, with rising fears that Germany could be slipping back into recession. But the ECB shows no inclination to cut rates with areawide inflation of about 2.2%, which is above the ECB's target level.

With the ECB holding its policy rate at 3.25%, real policy rates in the 12-nation region are about a percentage point higher than those in the U.S. More important, with inflation in Germany at only 1%, the ECB is forcing exceptionally high real rates on Germany at a time of acute economic weakness (chart).

Indeed, a strong case is emerging for a coordinated global easing of economic policy, says a study by Global Insight Inc., an economic consulting firm formerly known as DRI-WEFA. The company prescribes a series of global policy measures on interest rates, taxes, and spending, and estimates their impact would add 0.7 percentage points to growth in the Group of Seven nations in 2003 and an additional 0.8 points in 2004. Amid a growing possibility of global stagnation or deflation, the study argues that the risks of such policies are much smaller than the danger of doing nothing.

But while Fed action might spur foreign central banks, the Fed faces a dilemma at home: Lower borrowing costs cannot address the economy's current softness if that weakness reflects hesitation caused by domestic and international uncertainties. The Fed also risks using up its rate-cutting ammunition that might be needed later on if the economy's slump drags on. However, if the Fed urges policy patience even while the data remain weak, it will come under increasing attack for not acting sooner.

In this highly unusual business cycle, driven by an investment bust and a slew of unique institutional and geopolitical forces, Fed policy has been bold and well-timed. Now, after 11 months of holding rates steady, policymakers have to sit down and answer a key question: Have their past actions been enough?

By James C. Cooper & Kathleen Madigan

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