now powerless to fix whatever's wrong with the economy? That's one concern keeping many investors on the sidelines even in market rallies.
Initial claims for unemployment climbed to 442,000 in last week's report, significantly above the 410,000 expected by the majority of economists and above the 425,000 weekly average for the last four weeks. That average is itself at an 11-month high and seems headed higher.
A rise in the number of new claims doesn't guarantee an increase in the unemployment rate, now at 5.8%, because the economy creates new jobs even as some people lose theirs, and it's the net change that drives the unemployment rate.
But the traditional rule of thumb says that any initial claims number above 400,000 signals an increase in the number of unemployed -- even though some economists argue that with an increase in the size of the U.S. workforce over the years, 420,000 is a better cutoff. We'll know more when the report for April comes out May 2.
If the unemployment rate ticks further toward 6%, the pressure on the Fed to do something about the current weak economy will certainly increase, especially because Congress and the president don't seem about to deliver an economic plan that fills the average American with confidence.
Likely to Wait
The Federal Reserve is at a policy crossroads because the weapons that remain available to it for attacking the economy's weakness require a major policy shift by the U.S. central bank, one that could create new dangers for the fixed-income markets. That's why the Federal Reserve will probably wait until it's certain the economy isn't about to fix itself before moving again on interest rates.
The Fed has already cut its target fed funds rate for short-term interest rates to 1.25%. With inflation running somewhere between 1.8% and 3% annually, depending on what yardstick you use, the short-term fed funds target is already well below zero in real terms. Money invested at 1.25% is actually losing value right now.
And cutting short-term rates much further is likely to create problems for banks and money market funds that would have trouble attracting deposits and earning a profit at these levels. A fed funds rate of about 1% strikes many experts as a practical limit. Below that level, banks don't earn enough on short-term deposits to cover their costs.
So while many experts think the Fed has one more short-term interest rate cut available, the power of this tool seems about spent. And that's one of the major reasons that, despite the current stock market rally, investors remain so skittish. If the economy doesn't pick up, isn't the central bank just about out of ammunition? And if the Fed really is virtually powerless, aren't we in the soup if the economy shows signs of weakening further?
Well, no. The Fed has a lot more arrows in its quiver even after it shoots another 25-basis-point cut in short-term rates. Worries about the inability of the Fed to respond to a deepening of the current weakness in economic growth are overblown. Thanks to its ability to "manufacture" money, the Fed has almost unlimited power left to influence the fixed-income markets -- if it wants to use it.
But using these tools, what Fed watchers call "the other options," would require a major shift in current Fed strategy. The Fed knows that the other options have the power to give the economy a needed jolt, but the bankers also know that a sudden switch in policy could send the fixed-income markets into chaos.
Watch That Language
The Fed will make sure it has seen data that fully justifies using the other options before it moves. That's why the most likely move by the Fed when it meets on May 8 is no move at all. The fed funds futures market, which traders use to hedge possible changes in interest rates, is currently priced for just a 27% chance of an interest rate cut at the May meeting.
Watch the language coming out of that meeting. See if Alan Greenspan and company are signaling their intention to cut rates one more time if the economic numbers continue their recent weak showing. And look for trial balloons floated to get the fixed-income market thinking about the Fed's other options.
What are these other options? The Fed has the ability and power to influence interest rates by changing the rates banks pay to borrow funds overnight from money on deposit at the Federal Reserve banks (the fed funds rate) and by changing the interest it charges member banks for loans (the discount rate). These changes work at the short end of the interest rate curve, called the yield curve, and raise or lower the interest rates paid on instruments such as three-month Treasury bills and 90-day commercial paper.
But the Fed can also intervene in the financial markets to change interest rates at the long end of the yield curve by directly buying long-term Treasury bonds in the open market. That has the effect of lowering long-term interest rates because it increases the supply of cash, cash now in the hands of an investor who formerly held a bond. And it has the effect of increasing the money supply, which also acts to push down interest rates.
The advantage of direct intervention in the bond market by buying, say, 10-year Treasury notes (with the demise of the 30-year bond, those are now the longest maturity instruments issued by the U.S. government) is that it targets just one end of the yield curve, the one that has been most resistant to the Fed's efforts so far. While the three-month Treasury bill now yields about 1.16%, the 10-year Treasury still pays close to 4%.
In a two-step scenario, the Fed might first cut the target for the fed funds rate to 1% from the current 1.25%. If the economy keeps floundering afterward, the central bank would start buying long-term U.S. Treasuries to drive down interest rates at the long end of the yield curve. Driving long-term interest rates down to about 3.25% by buying in the open market would be relatively easy for the Fed.
The hope would be that reducing long-term rates would finally bring corporate borrowers back to the loan window. It would be an offer too good to refuse even if demand remains weak in many segments of the economy. At 3.25% plus whatever premium the market demands for a company's credit risk, a company is borrowing at not much more than the rate of inflation.
Pushing on a String
There is a danger that even cutting long-term rates to this level wouldn't stimulate the economy. The problem is called pushing on a string. No matter how cheap money is to borrow, companies aren't going to borrow if they can't make a profit on the money. That's the problem in Japan. The Fed has concluded that this kind of liquidity trap isn't likely here, and I think there's good reason to agree.
One of the oddest things about the current economy is the way that unit sales keep growing in sector after sector -- PCs, wireless phones, cars -- even while profits remain tough to come by. That unit growth creates at least a modest need for capital spending, and hence borrowing, at some point not too far down the road. And that's likely to head off a Japanese-style liquidity trap in the U.S.
But that doesn't mean a move by the Fed to lower long-term interest rates by intervening in the fixed income market would be without risk. Whatever the limitations of targeting the fed funds rate as an interest rate tool, it at least has the virtue of clarity.
If the Fed decided to try to manage long-term rates, how much intervention would be enough? Would the central bank target a specific rate for the 10-year Treasury -- even though the yield on that note fluctuates with other factors, such as overseas demand for U.S. bonds? And how would they communicate the magnitude and timing of their interventions to traders and investors so the market could remain the relatively orderly place that it is, yet avoid tipping the Fed's hand so much that the interventions would have no effect?
These problems aren't impossible to solve, but they would require a different set of ground rules than are currently in place and a different sort of communication between the Fed and bond investors than is currently in place.
The Fed would be happy to avoid going down this road. And that is just one more factor influencing it to wait.
Thanks to the Iraq war, the fixed-income markets bid down short rates and bid up long rates as investors looked for safety and avoided the greater risks in longer-term paper. Foreign investors who are big buyers of long-term U.S. notes avoided U.S. financial assets because of the war, and that bid long-term yields up too. Now that the war's over, the Fed will be waiting to see if some of that gap between short- and long-term rates closes on its own.
Add the uncertainty created by the war for anyone trying to figure out how weak the economy really is, and I think you've got a recipe for caution and very clearly telegraphed moves by the Fed in the next few months.
The Fed still has tools it can use to help the economy. But the bankers would indeed prefer not to use them.
Jim Jubak appears Wednesdays on CNBC's "Business Center" at approximately 5:45 p.m. ET. At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.