What Recession? It's Not All Doom and Gloom

Since Federal Reserve Chairman Alan Greenspan's testimony before the Senate Budget Committee, it has become clear that the Federal Open Market Committee will cut the fed funds rate by another 50 basis points at the end of its two-day meeting on Wednesday. After the surprise 50 basis-point cut delivered on Jan. 3, I had previously expected the Fed to return to the gradualism that has characterized Greenspan's tenure.

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Oh, my fundamental analysis of the U.S. economy hasn't changed. I'm still in the camp that says that while a slowing of the U.S. economy is clearly evident, the abrupt downturn in the last six to eight weeks of 2000 probably exaggerated the magnitude of the slowdown. In addition, the rate cut earlier this month has helped ease the strains in the financial markets.

Indications of What's to Come

Here's what I'm looking at: Weekly initial jobless claims , which spiked to 380,000 in December, have fallen to 316,000 in the most recent period. The four week-moving average, which helps smooth out the volatility in the high-frequency time series, has fallen to 336,000 from 362,000 at the start of the year. This is still consistent with a modest easing in the labor market, but it has backed away from recession territory.

Consumer demand is also improving. Visa reported that restaurant outlays increased sharply since the start of this month. Chain-store sales have been reported above plan. The National Association of Manufacturers observed last week that manufacturing is rebounding.

The colder-than-normal weather last month may have helped to depress economic activity. The prolonged election uncertainty also may have contributed to the poor economic performance at the end of last year. A return to more normal weather conditions, a resolution to the election and any decline in oil prices should help bolster other measures of economic performance.

The decline in market interest rates has fueled a surge in mortgage-refinancing operations. The costs associated with refinancing can be recouped over the next few months and will then free up new disposable income. The Fed's 50 basis-point cut at the start of the year has eased the restrictive conditions in the capital markets. Credit spreads have narrowed.

The high-yield corporate bond market has been impressive in terms of new issuance and returns. Levi Strauss and American Tower (AMT Quote - Cramer on AMT - Stock Picks) increased the size of their offerings. Global Crossing (GX Quote - Cramer on GX - Stock Picks), Nextel (NXTL Quote - Cramer on NXTL - Stock Picks) and Allied Waste (AN Quote - Cramer on AN - Stock Picks) also have successfully sold high-yielding bonds.

In fact, this month's new issuances are a full quarter of the last year's nearly $43 billion of new junk-bond issues. On an index basis, the spread over U.S. Treasuries has fallen to about 7.5% from 10%. Since the Fed's cut, investors have poured nearly $2 billion into high-yield mutual funds, according to AMG Data Services. Even with a little backup as the market digests the deluge of supply, the return on junk bonds this month alone will largely offset the little more than 5% loss experienced for all of last year.

The Greenspan Factor

However, the trick to Fed watching is not to argue what we think the Fed ought to do, but rather what the Fed will do. Greenspan's testimony was as clear of a sign as we could possibly expect that the Fed will deliver another 50 basis-point rate cut on Wednesday. Greenspan said three things that convinced me of this: Growth is near zero; the economy is in the midst of a significant inventory correction; and the California power crisis is significant. Other Fed officials had indicated that while they were watching the California situation, they thought it looked more like a local phenomenon with little impact on the overall economy.

One omission also makes me believe that Greenspan is prepared to cut the Fed funds rate by 50 basis points rather than 25. By not citing the contrary evidence -- by not defending the Fed's baseline forecasts that the U.S. economy is not bound for a recession -- Greenspan effectively validated market expectations. This is important because the surprise cut earlier this month was partly explained in terms of validating market expectations. Much to my frustration, the February fed funds contract has consistently priced in a strong chance for another 50 basis-point move. A Reuters poll found that 24 of 25 primary dealers expect a 50 basis-point cut, up from 12 dealers in the previous poll two weeks ago.

How Low Will Greenspan Go? The Fed will lower interest rates by 25 basis points. Why stop at 25? Let's try 50. I work for Daimler Chrysler. Is 100 out of the question? Not at all.

Greenspan also endorsed tax cuts. He justified the seeming shift in his stance on the fact that larger-than-projected budget surpluses are now forecast and that the government could be debt-free by the end of the decade. He also seemed unusually concerned about the implications of a debt-free government and that it would then have to accumulate private assets with its budget surpluses. Although Greenspan has no direct say in U.S. fiscal policy, his stature gives him influence beyond his job description. The Bush administration is as happy as pig in mud that it apparently got Greenspan's blessings for its fiscal plans.

The trajectory of the U.S. policy mix already was moving in the direction of more accommodating fiscal and monetary policies. But Greenspan's comments suggest that the magnitude of each may be greater than previously believed. In contrast, higher-than-expected January inflation data from Germany and Italy (which together account for nearly half of the eurozone's inflation) and comments from European Central Bank officials indicate that while fiscal policy may have eased via tax cuts, monetary policy will not be eased any time soon. The divergent policy mixes will weigh on the dollar against the euro over time. The dollar was trading at its best levels of the year against European currencies before Greenspan's testimony helped trigger a sharp reversal of the dollar's fortunes.