What Will the Fed Do Next? A Forecasting Guide

Just before the Federal Reserve lowered the fed funds rate by 50 basis points last week, many Wall Street economists were predicting a cut of 75 basis points, or 0.75%. And for weeks, strategists were saying (hoping) the Fed would cut rates between meetings.

Based on my own study of Fed behavior, I had been telling my clients since February that 50 basis points was the probable change and that the Fed would not move outside its regular eight-times-a-year meeting schedule.

What did I see that was different from the consensus analysis?

To recap, the Federal Reserve has two missions:

To promote growth in the economy and full employment
To prevent economic instability by keeping inflation under control

It's not part of the Fed's mission to "save" the stock market, although certain coincident events might lead investors to think so. For example, from August through October 1998 during the Russian and Asian financial crisis, the Fed moved aggressively to cut rates and flood money markets with liquidity to offset the impact of the collapse of Long-Term Capital and several other hedge funds. Coincidently, the U.S. stock market, which had been falling sharply since late summer, rallied sharply and closed out the year near the highs. Thus was born the myth of the "Greenspan Put," the idea that the Fed would bail out investors with increased liquidity whenever stocks got in trouble.

The main difference between 1998 and last year is that in 1998, the stock market sold off sharply in the face of external events (another example, the Iraqi invasion of Kuwait in 1989). The deterioration in stock prices over the last year is strictly an internal development -- high stock valuations weren't sustainable given a saturation of capital spending, particularly in technology, and a sharp deceleration in earnings growth rates. So stock prices have come down 65% on the Nasdaq and 25% on the S&P 500 since March 2000.

The Fed has had a tricky job in recent years. Changes in productivity have clearly pushed the sustainable, noninflationary growth rate of the economy higher. Traditional studies suggested that 3% was the maximum sustainable rate, but now the target might be 3.5% or even 4%. Last year the U.S. economy saw growth rates of more than 7% with only a minor up-tick in inflation, as you can see below.

In fact, if energy prices hadn't doubled from the lows of summer 1999, inflation would probably still be under 2%.

The Fed started worrying about inflation in fall 1999 and began pushing the fed funds rate higher, from 4.5% to 6.5%.

However, the U.S. economy, as measured by the gross domestic product continued to expand rapidly through the summer of 2000.

How? Well first of all, there's a six- to nine-month lag between the time a Fed policy changes and when its effects are felt in the economy. Secondly, there's another, lesser-known tool the Fed uses to control monetary policy: controlling growth in the money supply. In the fall of 1999, the Fed allowed money-supply growth to surge out of concern that Y2K computer problems would adversely impact the economy. For more on how the Fed controls money supply, see Purposes and Functions of the Federal Reserve Bank on its Web site. And for even more background, see my column, Learn to Read Economic Indicators Like a Fed Governor.

Raising rates while allowing the money supply to expand is the equivalent of pressing on the brakes and the gas of a car simultaneously -- the car may well accelerate. At year-end 1999, money-supply growth was above 8%, and GDP growth hit 8.2%. Once it was clear Y2K was a non-issue, the Fed sharply reduced growth in the money supply. By the fourth quarter, GDP growth had fallen to 1.1%.

The Fed has cut the fed funds rate by 150 basis points since the start of the year. Recently, the growth rate of the money supply has increased; now it's just under 8% on an annualized basis.

Although the Fed does not target stock market levels per se, the evaporation of about $4.5 trillion in stock market capitalization over the last year has raised the specter of a "poverty effect." Just as consumers were inclined to spend more, save less when stock prices were soaring, they now may be inclined to save more, spend less. By increasing money-supply growth, making more money available to borrow at lower rates, the Fed hopes to offset the "poverty effect" before GDP growth turns negative (two consecutive negative quarters is the definition of recession).

However, it's clearly too late to avoid a corporate "earnings recession" (defined as two quarters where S&P 500 earnings contract). According to Thomson Financial/FirstCall estimates, earnings for S&P 500 companies, on average, should fall 7.2% in the first quarter and 5.2% in the second quarter.

So what will the Fed do? In aggregate, I see the economy growing below trend for a couple of quarters. However, with unemployment at 4.2% (half the peak of the 1993-94 recession) GDP growth still positive and interest rates once again approaching the lowest levels in a generation, economic growth should pick up toward a 3% to 3.5% rate by year-end. I certainly do not expect the Fed to move before its May 15 meeting, and I expect no more than a 25-basis-point move lower in rates.

The stock markets haven't responded to the three Fed cuts so far, but with money supply growing rapidly as well, it's just a matter of time before stocks resume moving higher. As I've repeatedly told clients in recent weeks, the one thing not to do right now is sell.

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David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. At the time of publication, his firm held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards invites your feedback at [e-mail].