Semi-Daily Journal

We now believe the Federal Reserve will ease monetary policy at its meeting next week by 50 basis points to insure that emerging economic weakness doesn't turn into a double-dip recession.  The call is a tough one for a Fed that only three weeks ago expressed new confidence in a solid 3% second-half growth rate.  It's a big change for us, as well.  Growing signs of weakness over the past month had increased downside economic risks; but the tipping point was new signs of consumer pullback in July.  We'll concede that Fed officials may still want further evidence before moving.  If we are wrong and the Fed does not change rates next Tuesday, we expect officials to ease by the September 24 FOMC meeting.  While such a move would take the Federal funds rate to an unprecedented 1.25%, we believe additional ease is possible if economic weakness spreads.

As we contemplated the rapidly shifting risks for monetary policy over the past few weeks, two criteria seemed necessary for a change.  Either evidence of a faltering economy or capital market dislocations that could jeopardize economic activity would be sufficient grounds for ease.  In our view, both have emerged as clear threats in recent weeks, but the pronounced hesitation in economic activity is the most important factor.  To be sure, Fed officials have lately expressed confidence that recovery is on track, and we've made similar arguments.  But the balance has suddenly tipped in the other direction, making the risks for policy asymmetric.  Thus, we believe that officials want to insure that this economic hesitation does not turn into a broader-based economic slowdown.

Signs of weakness have been accumulating over several weeks, and the corporate governance-cum-equity shock is clearly taking its toll on consumers and businesses alike.  Most important, we believe July's data suggest a sudden turn for the worse.  Retailing, especially for big-ticket durables, and consumer spending on some services apparently slipped significantly in July.  Reports from chain stores suggest that July's results were much weaker than June's.  Although some retailers reported insufficient inventory of seasonal merchandise, the sudden fall-off in discretionary items such as consumer electronics hints at hesitation in demand rather than weakness in supply.  Businesses remain cautious about hiring and capital spending.  Although jobless claims have trended lower recently, with the four-week average at 15-month lows, that seems to suggest fewer layoffs rather than increased hiring.

We believe that financial market dislocations that could short-circuit the expansion are a second factor behind the Fed's desire to take out insurance against a weakening economy.  But why ease now?  After all, growing expectations of Fed ease and the announcement of a massive bailout package for Brazil have eased the strains in credit markets.  Risk spreads have narrowed, high-quality issuers can come and are coming to market, and secondary trading has improved.  The rally in stocks, especially in financial names, is also helping to ease concerns of a credit crunch.  But while these growing signs of relief are encouraging, corporate debt spreads and markets are highly volatile, lenders remain cautious, and financial restraint is still an issue for the outlook.  Traders could react negatively to Fed action, assuming that that the Fed knows something that they don't.  Nevertheless, in our view, the evidence on the economy is now sufficiently weak to warrant the move.

We believe this double-dip insurance likely will contribute to better growth prospects in 2003, and markets are beginning to price that in.  But first, market participants and policymakers will have to navigate the immediate outlook, which looks bumpy.  We believe actions taken now won't help the immediate outlook, but they will lay the groundwork for a significant improvement in 2003.