The Fed Will Keep Easing

When the Federal Reserve suddenly cut its target for the federal funds rate between meetings earlier this month, it prompted a rash of speculation that the Fed knew something that the markets didn't. Rumors flew that the Fed had advance warning that the employment number due out a few days later would be stunningly weak, or that a major financial player was in trouble.

As Vice-Chairman Roger Ferguson said in a speech last week, that was not the case. Business activity slowed markedly in the last three months of the year, and the board, after changing its bias in December from tightening to easing, wanted to see confirmation of the weakness in the December data before it pulled the trigger. It got this confirmation in the National Association of Purchasing Managers' data, released the day before the rate cut, and from the release of disappointing holiday numbers from retailers such as eToys (ETYS - Cramer's Take - Stockpickr), Federated (FD - Cramer's Take - Stockpickr) and The Gap (GPS - Cramer's Take - Stockpickr), among others.

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It turns out that the headline payroll employment figure wasn't terribly weak, coming in with a gain of 105,000 jobs in December, and hourly wages rose a surprisingly strong 0.4%. Coupled with Friday's strong Producer Price Index number that slammed the bond market, a few people that I talk to are now wondering if the Fed may be prevented from lowering short-term rates again when it meets on Jan. 31. The answer is no.

The employment number was not as strong as it looked: 56,000 of the jobs created last month were in the government sector, indicating that private-sector job creation was indeed weak. I don't believe that the strong wage growth will worry the Fed too much. Wages are a lagging indicator, and if this payroll weakness persists, they will eventually slow. The strongest impression that I took away from the employment release was the data on total hours worked.

Cutting Back Employers are holding onto workers in case business rebounds, but are limiting the growth in hours that they work.

This index is a good proxy for changes in economic activity because it measures not just how many people are working, but also how much they are working. By last September, the growth in hours had fallen to the low end of its range for the past three years. October and November saw significant slowdowns, but December produced a stunningly sharp decline in growth.

The hourly data would seem to be a much better indicator of what is going on in the economy than the payroll data. The divergence makes sense because, until a few months ago, the No. 1 problem for most companies was finding qualified employees. If the fourth quarter's slowdown proves to be temporary, then cutting payrolls now would put employers in a bind. It makes more sense for employers to try to hang on to the workers they have, in case business rebounds, but to cut the hours they work.

Friday's PPI number of 0.3% was way above expectations for an unchanged figure, but I don't believe that this will preclude further rate cuts. The Fed tries to look forward, and so it focuses on inflation pressures more than on current headline numbers. With the slowdown of the last few months, and with the collapse of oil prices, inflation risks have been sliced.

How much more will it cut? That's hard to say, because the answer will partly be determined by the behavior of financial markets, especially the bond market. Economists seem to be split as to whether or not we are in a recession. Even if we technically are not in one, the transition from fast to slow growth sure has the feeling of it, and argues for lower rates. I'm reminded that Anirvan Banerji pointed out a few months ago that we haven't had a rise in oil prices like last year's without a recession following it.

If we do actually avoid one, it will be viewed as a minor miracle. That the CPI only increased from 1.5% to 3.5% despite oil's tripling should be viewed as a minor miracle, and is probably partly due to the Fed's preemptive stance that began in 1999. Fixed-income investors were comfortable that the Fed would not let inflation get out of hand, and the bond market is now firmly on the Fed's side.

The bond market staged a powerful rally following the Fed's action, and actually got ahead of itself until Friday's PPI and stronger-than-expected retail sales data were released. Fixed-income markets are now priced to expect a quarter-point cut in the Fed funds rate at the end of this month, and another half-point later this quarter.

The lower that long-term rates go (and I'm talking more about corporate yields than Treasury bonds ), the less the Fed will have to do. I believe the easings that are expected will occur, though people will worry about the creation of another asset bubble, similar to what followed the rate cuts of 1998, if long-term rates fall sharply.

I don't view another bubble as very likely. Unlike 1998, this economic slowdown is real, so it will take time for business to reaccelerate. More important, as I wrote on the Columnist Conversation earlier this month, the timing of the Fed cut may help to prevent another bubble by taking Cramer's fictional go-go investment team of Buzz and Batch out of the picture. By postponing the ease from December into the new year, the Fed may have prevented Buzz and Batch from gunning up their momentum stocks. If the Fed had cut rates in December, those momentum funds that were down 40% could have ended the year down by only 15% to 25% (with some decent year-end markups) and started the money-gathering process anew.

With the cut in rates not having come until January, those funds are now saddled with a minus-40% year on their record. As many people buy funds based on track records (hence the plethora of fund ads that Herb Greenberg was railing against recently), it will be very difficult for Buzz and Batch to mount an effective ad campaign with a one-year number like that. People are reluctant to give money to someone who lost nearly half of their clients' assets -- and more in some cases -- in just a year's time.

With a smaller possibility of a bubble, further rate cuts are now more likely. It's tough to say how many more are in store, but the key thing for investors to keep in mind, as I pointed out in December, is that the Fed is now in an easing mode, and that bodes well for financial assets.