The WSJ's Take on the Current Attitude of the Fed

Greg Ip and E.S. Browning of the Wall Street Journal sketch out their take on the current attitude of the Federal Reserve. It seems to be that short-term interest rates are already so low that spending has to recover and grow sometime in the future.

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WSJ.com - Fed Leave Rates Unchanged, But Dissenting Votes Emerge: ...The Fed's widely expected decision to keep its short-term interest rate at the 41-year low of 1.75% left the door open to cuts in the federal-funds rate later this year, perhaps to mitigate the impact of a potential war with Iraq. A statement announcing the decision, and dissents by two of the Fed's 12 voting policy makers in favor of an immediate cut, suggested a greater inclination toward lower rates in coming months -- possibly before the next scheduled meeting, in November. The statement said that risks are tilted toward economic weakness rather than inflation, similar to a Fed comment after its previous stand-pat decision in August...

Fed Leave Rates Unchanged,
But Dissenting Votes Emerge

By GREG IP and E.S. BROWNING
Staff Reporters of THE WALL STREET JOURNAL

Amid intensifying worries about the economy, the Federal Reserve Board voted to hold interest rates steady, prompting rare dissents from two members and sending the jittery stock market to its lowest level in years.

The Fed's widely expected decision to keep its short-term interest rate at the 41-year low of 1.75% left the door open to cuts in the federal-funds rate later this year, perhaps to mitigate the impact of a potential war with Iraq. A statement announcing the decision, and dissents by two of the Fed's 12 voting policy makers in favor of an immediate cut, suggested a greater inclination toward lower rates in coming months -- possibly before the next scheduled meeting, in November. The statement said that risks are tilted toward economic weakness rather than inflation, similar to a Fed comment after its previous stand-pat decision in August.

'Considerable Uncertainty'

Over time, today's low interest rates and high productivity growth should "foster an improving business climate," the policy makers said. But "considerable uncertainty persists about the extent and timing of the expected pickup in production and employment, owing in part to the emergence of heightened geopolitical risks" -- an apparent reference to the prospect of a war with Iraq.

"They opened the door wider to a rate cut, certainly wider than a month ago," said Peter Hooper, chief U.S. economist at Deutsche Bank.

Economic data released Tuesday underscored the loss of economic momentum. The Conference Board's monthly consumer-confidence index fell 1.3% in September, to 93.3, from an upwardly revised 94.5 in August, its fourth-straight decline. The drop was fueled in particular by consumers' assessment of current economic conditions. The index of consumers' assessment of their present situation plunged nearly 5%, to 88.5, the lowest since 1994, but the index of expectations rose 1% in September to 96.5. Despite interest rates that continue to edge lower, the number of consumers who say they plan to make a major purchase soon -- of a car, house or appliance -- fell from the month before.

Though no surprise, the Fed's decision disappointed investors, and the dissent within the central bank appeared to spook them. Fed Chairman Alan Greenspan in July reassured investors that the economy is recovering and that no further Fed action is needed. Now comes word that two of his fellow decision-makers think he is wrong, traders said. The Dow Jones Industrial Average fell 189.02 points, or 2.4%, breaking through its July nadir and closing at 7683.13, a four-year low. The industrials haven't been this low since Oct. 1, 1998, when stocks still were reeling in the wake of the Russian debt default and the near-collapse of a huge hedge fund, Long Term Capital Management.

Wall Street's Worry

Wall Street's big worry now, in a nutshell, is a loss of confidence in the ability of major American corporations to pull their earnings strongly out of a yearlong slump. On April 1, Wall Street analysts forecast a 20% rise in earnings for companies in the Standard & Poor's 500-stock index for the third quarter. Now, the profit gains for the period are forecast to be just 8.5%, according to Thomson First Call, and some analysts fear they could be even slimmer.

Coming on top of the earnings worries, and of fears about the impact a war with Iraq could have on oil prices and world stability, the Fed inaction appears to have driven more investors to the sidelines. In effect, they have decided that their best course of action is to pull back from stocks and wait for the storm to pass. "I've seen a distinct lack of buyers in the marketplace," said veteran stock trader Bob Basel of New York brokerage firm Salomon Smith Barney. "It is almost like a buyers' strike."

The Fed is just the latest in a series of worries weighing on Wall Street. "I don't think the whole 189-point loss can be attributed to the Fed. You have to put it in the context of the other events that have been going on for the past two weeks or more," Mr. Basel said, pointing to deteriorating earnings forecasts and the steady pounding of war talk.

Over the past few days, hopes had begun to build that the Fed might step in and cut its target rates. Investors now are looking ahead to the release next Tuesday of the September survey of manufacturing activity by the Institute for Supply Management. If manufacturing activity proves weak, the thinking goes, the Fed could be spurred to cut rates as a signal of its determination to keep the economy from sinking back into recession. In the view of Wall Street analysts, the biggest brake on corporate earnings is the weakness of new capital spending by big companies. One hope is that, if the Fed cuts interest rates further, consumer spending would remain healthy and encourage new business investment.

Policy makers are "faced with a dichotomy between economic numbers which are not doing terribly -- consumption spending was reasonably strong in July and August -- and all the forward-looking indicators, most obviously the stock market, which are signaling pronounced weakness to come," said Ram Bhagavatula, chief economist at Royal Bank of Scotland.

Some observers have speculated that the Fed is keeping its powder dry so it will have room to cut rates later. But Fed officials have indicated in the past that they would not delay cutting immediately to try to pre-empt a severe economic contraction.

The Fed's task is especially difficult right now. Some of the biggest threats to the economy are hard to quantify, such as the impact of corporate governance scandals, the bear stock market and the likelihood of war with Iraq. The war talk has already sent the price of oil to more than $30 a barrel, a level that has in the past foreshadowed a recession.

Reflecting the difficulties the central bank faces, two policy makers -- Gov. Edward Gramlich and Federal Reserve Bank of Dallas President Robert McTeer -- broke with Chairman Greenspan and their other colleagues, publicly declaring themselves in favor of a rate cut. It was the first dissent in favor of cutting rates since 1995.

Mr. Gramlich's vote is especially noteworthy. Since joining the Fed in 1997, the former academic has developed a reputation for urging more aggressive action on both raising rates and lowering them, but he has never felt strongly enough to dissent. His decision indicates a strong conviction that the economy needs help quickly. By contrast, Mr. McTeer has long had a reputation as a dove, dissenting twice in favor of not raising rates in 1999.

However, the majority of policy makers appear confident that interest rates should be low enough to keep the economy growing, saying in Tuesday's statement that overall spending is now growing at a "moderate" pace. It would take additional weak economic data to shift more officials into the rate-cut camp. Private economists expect the economy to grow at an annual rate of almost 4% in the quarter ending next week. But they see signs it will slow sharply in the fourth quarter, such as rising claims for unemployment insurance, slowing auto sales and a drop in new home construction.

-- Andrew Caffrey contributed to this article.

Write to Greg Ip at greg.ip@wsj.com⁸ and E.S. Browning at jim.browning@wsj.com⁹

Posted by DeLong at September 25, 2002 12:52 PM | Trackback