Rate Cuts: The Fed May Just Be Warming Up

The half-point reduction isn't enough to erase the risk of recession

Score one for the Fed. Facing both deteriorating financial conditions and new risks to economic growth, the Federal Reserve stepped up to the plate on Sept. 18 and hit more than just a solid single. This one went for extra bases. The Fed's half-point cut in its target interest rate, to 4.75%, was well beyond the quarter-point reduction most Wall Streeters were expecting. And the policymakers left the door cracked for further trimming "as needed." The question now: Will more be necessary?

Probably. The big cut lessens, but does not eliminate, the chance the Fed will cut again at its Oct. 30-31 meeting. The Fed sounded as uncertain about how the recent credit turmoil will play out as anyone, so much so that it avoided offering its usual assessment of whether economic growth or inflation was its primary concern.

Nevertheless, as long as uncertainty and fear continue to prevent the proper functioning of the credit markets, economies in the U.S. and abroad will be at risk. The Fed's action will go a long way toward restoring confidence in businesses' access to the funding they need to operate, but even a half-point decrease won't quickly thaw out frozen markets or reverse the downdraft already hitting economic activity.

The latest victim of the credit debacle is the London-based mortgage lender Northern Rock. On Sept. 17 the British government had to step in to halt an old-fashioned bank run. The otherwise healthy institution depended heavily on the credit markets for funding, and it got caught in the squeeze. Now the government fears the panic could spread to other banks. Because credit markets are now global, the Fed's big move may help to stabilize markets overseas as well.

IN THE U.S., THE RATE CUT was a preemptive move aimed squarely at the economy, but it will not likely be enough to remove the risk of a recession. It's clear the economy is already slowing because of the credit crisis and will continue to do so, perhaps sharply, over the next couple of quarters. So far the data are not uniformly negative, and economists generally expect the top-line number on third-quarter growth to be about 3%. But that's because the economy began the quarter strongly. Much of the latest data are much weaker, including a continued slide in August housing starts, suggesting little momentum heading into the fourth quarter.

Several key reports for August, the month when the severity of the credit turmoil first came to light, took an abrupt turn. Retail sales, outside of autos and gasoline, had jumped 0.8% in July, but they dipped 0.1% in August. Factory production, which advanced 0.7% in July, fell 0.3% in August, and the downshift was broad, including business equipment, suggesting companies may be having second thoughts about their expansion plans. Dimmer business expectations would be one explanation for the surprise dip in August payrolls.

IT'S ALSO INCREASINGLY EVIDENT that the Fed's previous inflation worries will not stand in the way of rate cuts. The policymakers' post-meeting statement significantly downgraded its Aug. 7 assessment of inflation risks, mentioning nothing about the danger of "high resource utilization." That's because the economy appears to be slowing to a pace below the 2.5% or so where the Fed believes job markets start to loosen up and the unemployment rate begins to rise. If so, then the Fed's earlier concern that tight labor markets could fuel inflation would become moot.

Fed Policy Has Tightened This Year
Broadly speaking, financial market shocks, such as those in 1998, 2000, and now 2007, are deflationary events. Falling asset prices, this time including home prices, put downward pressure on demand by consumers and businesses, which eases any steam under prices.

In fact, the Fed's preferred inflation gauge, the price index for personal consumption expenditures excluding energy and food, is already dropping. The rate has declined steadily all year, declining from a peak of 2.5% in February to 1.9% in July. Moreover, the modest 0.2% advance in the August consumer price index outside of energy and food implies the Fed's closely watched price measure will edge lower. The gauge is already safely within the 1%-to-2% comfort zone of most policymakers.

One thing largely unnoticed, which may also have influenced the Fed's big move, is that the drop in inflation has actually made policy a lot tighter than it was heading into the credit crisis. How so? One measure of the stringency of Fed policy is the real target rate, which is the federal funds rate adjusted for inflation. Even though the Fed had left its target rate steady until Sept. 18, the real policy rate had risen from 2.8% in January to 3.4% in July because of falling inflation.

That rate is well above the historical average of 2.4% that serves as a proxy for a neutral policy—the point where the target rate neither boosts nor restricts growth. Prior to Sept. 18 the Fed's 5.25% target rate was already in the zone where policy was holding back growth, even before the drag from the credit mess in August. Now the Fed has acted to make policy less restrictive, but the real rate is still at about 3%, suggesting that more rate cuts may be needed to ensure the economy has enough financial fuel to avoid stalling.

CORPORATE BOARDROOMS are becoming more cautious, and that will put a damper on plans to expand facilities and payrolls. The Business Roundtable's third-quarter survey of more than 100 CEOs around the country showed a steady erosion in optimism. The Roundtable's CEO Economic Outlook Index, comprising executive expectations for sales, capital spending, and hiring, fell to its lowest level in four years.

The business group's survey, which was completed between Aug. 20 and Sept. 5, also asked the CEOs whether recent credit woes would affect business prospects, and 40% said they expected "substantial effects." Of that 40%, more than 60% expected the biggest impact to come from weaker economic growth.

Corporate Execs Show Fading Optimism
As long as companies feel skittish, workers will be vulnerable. The household sector has shown remarkable resilience in the face of adversity in recent years, but the next few quarters will be its most severe test yet. Two factors have kept consumers spending: strong income increases generated by new jobs and additions to household wealth coming from stock market gains and rising home values. The new mix of a weaker economy, tighter credit, and falling home prices puts those supports at risk.

The only remaining question about the Sept. 18 rate cut is whether the policymakers have moved too late to stave off a recession. Not even the Fed knows the answer to that, but several things are certain: Cutting rates now, and in a big way, will boost housing affordability and help some homeowners cope with higher adjustable rates. It will shore up market and business confidence, and it will make the dollar even more competitive in foreign markets, boosting exports. But all that doesn't add up to a victory for the Fed. It will most likely take another hit or two to win the game.

By James C. Cooper

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