Wall Street is keenly focused on the
Federal Reserve's policy meeting this week, as investors await this year's anticipated sixth cut to interest rates in a decision to be announced Wednesday afternoon.
Alan Greenspan and friends have already dropped
short-term rates by 250 basis points to 4% since the beginning of this year -- one of the Fed's most aggressive rate-cutting schedules in recent history -- in a bid to get the economy back on its feet.
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The market seems pretty evenly split over whether the Fed will slash another quarter point or half point from the fed funds target this time around. At the end of the trading day Monday,
fed funds futures, a good gauge of what the bond market is expecting, were pricing in 54% odds of a half-point cut and 100% odds of a quarter-point cut. Meanwhile, 10 of the 25 primary bond dealers who work with the Fed expect a 50 basis-point cut, while 15 are forecasting a 25 basis-point reduction.
Jim O'Sullivan, senior U.S. economist at
, is among those who anticipate a half-point cut.
TSC: Why are you expecting a half-point interest-rate cut?
Well, certainly the economic numbers continue to be very, very weak. I mean, I think a couple of weeks ago, it was looking like they might phase down just a quarter point. You were hearing about how monetary policy works with a lag, and they'd already done 250 basis points, and fiscal policy was starting to work as well, with a big tax cut coming. Plus, the bond market had sold off, and Fed officials were starting to sound a bit more defensive about the inflation outlook.
But, obviously, the mood has shifted in the last couple of weeks. The economic numbers have continued to come in weaker than expected. Two weeks ago, you got another rise in the four-week average of
job claims, not only the main number, but also the downward revision to April. And also, the core
CPI number for May, coming in at 0.1 was much better than expected, and the bond market has rallied as well. So several things have tilted the odds back in favor of a 50 basis-points move. It's still a close call certainly, but the weight of evidence at this point would support another move of 50 points.
TSC: Do you foresee more rate cuts after that?
Our forecast has them stopping after this week at 3.5%. Having said that, there's still some risk that 3.5% won't be enough, and certainly with the statement, we'll almost certainly still have a bias toward continued risks of weakness.
TSC: What will the Fed watch most carefully in the next few months to determine whether more rate cuts are needed?
If I had to pick just one single number, I would pick jobless claims for the next couple of months. I think they've been an excellent indicator of the weakening in the economy and the need for Fed easing. So I think if you were to see jobless claims turn around, that would be a sign to the Fed that the economy has reached a turning point. So far we haven't seen that. Obviously last week we saw the weekly claims number take a big drop, but that was just one week and the four-week average barely changed, so now there are eight weeks before the next meeting. A lot can happen between now and then.
More generally, they look at everything. If you're going to look for candidates, one of them is inventories in the manufacturing sector. The Fed has been pointing out the inventory correction is well-advanced, and we'd be looking for the drag from inventories to start to fade a bit, and that should help the manufacturing number. In turn, that will be reflected in the jobless claims number.
The other area is the consumer. And there are a couple of potential pluses out there for the next couple of months. One obviously is the tax cut. And that starts kicking in during July. So going into the August meeting, we won't have a lot of information.
TSC: With mounting concerns over consumer spending and with household wealth down considerably from last year due in part to stock market losses, talk of the negative wealth effect is growing. How seriously is the Fed taking stock market losses right now?
I think they always take it into account. ... They always insist they're not targeting the stock market, they're targeting the economy, but one of the drivers of the economy is the stock market. The stock market has bounced a bit since March. That is a plus relative to a few months ago. You can focus on the fact that the stock market is still down pretty far from a year ago, and that's a negative. And to the extent the wealth effect works with a lag, that's still holding down consumption.
The stock market has been more flattish over the past month or so, but it is up a bit since March. If you were to start seeing the stock market tumbling again, then that would put pressure on them to keep on easing.
TSC: Why do you think the first five rate cuts haven't had any impact on the economy yet?
Point No. 1 is certainly that it takes time. They only started in January, so it's not even six months since the first cut. And monetary policy typically does work with a lag. So that's certainly part of the story. And No. 2, it may well have worked. Maybe the economy would have been even weaker without the easing.
In the Fed's own model, lower fed funds rates work through several channels: market interest rates, the stock market, the dollar and general expectations. As you look at those things so far, the bond market is down from a year ago. And I think the market kind of moved in advance of the Fed in the second half of 2000. So the bond market hasn't done a whole lot this year so far, but it's definitely fallen since a year ago. And it's helped keep the housing market stronger than it would have been otherwise.
TSC: But haven't long-term bond prices fallen more moderately than was expected?
They're expected to drop maybe half as much as the fed funds rate, and the fed funds rate is down at this point 250 basis points from a year ago, and long-term rates are down close to 100 basis points. Mortgage rates were over 8% in May of 2000, and now they're more like 7%. The additional drop in 2001 has not been great, but there hasn't been much additional decline lately, certainly. And that's limited the effectiveness of the easing somewhat.
The other thing is the dollar, which has continued to strengthen, though the model suggests it is supposed to decline. And the stock market is still down on the year, even though it's up since March. So those have all limited the effectiveness. But certainly part of it is that the economy lags the rate cuts.
The other point I'd make is that monetary policy is not especially stimulative yet, in that you started from a fairly tight point. Fed funds were at 6.5% and core inflation was at 2.5%, so it was a 4% real yield, which is very, very tight. Whereas now, if you get 50 basis points this week, you're down to 3% nominal, which is 1% real, which is a bit below the average of 2. So a lot of the easing was simply taking out tightness in monetary policy.
TSC: When was the last time the Fed cut interest rates this aggressively, and what kind of impact did it have on the economy then?
Certainly in the Greenspan era it hasn't happened. If you look at the
era, the numbers are so much bigger. Rates probably came down faster, but from a much higher level.
So, this has been, certainly, a very rapid response. But arguably it's been appropriate in that the stock market took quite a drop from a year ago. And the stock market is so much more important than it used to be, so they've really got to offset that drag.
TSC: When are you expecting the economy to pick up again?
Our forecast has
GDP doing a bit better in the third quarter, but a negative number for second quarter -- or a contraction of 1% at an annual rate -- and then we're saying plus 1.8% growth in the third quarter. So for that to happen, you'd want to be seeing stabilization at least in the July data. And the August data should show some improvement. So, if you're not seeing that when the August meeting comes around, then the Fed may well have to ease again, but we're pretty much assuming that this is the worst quarter and that in the third quarter you see at least some improvement.
TSC: What makes you think the economy will recover in the third quarter?
Inventories are part of the story. There's been a major cutback in inventories. They've gone from plus $70 billion at the end of last year to minus $20 billion or so in the first quarter. So there's been a major inventory correction, and that shouldn't have to be repeated. So that drag from inventories should start to fade. And in a relative sense, that's a plus, so it should help GDP do a bit better.
And the other thing is the tax cuts should help, starting in July. The numbers, at first, don't sound huge. There's a $38 billion rebate in the third quarter. That's about 0.5% of annual disposable income, so it's not a huge amount of money. But when you pay it all in one quarter, it adds up to 2% of that quarter's disposable income. And then when you actually annualize it, it adds 8 percentage points to the annual rate of growth in disposable income in the third quarter alone. Everybody expects that the majority of the rebate will be saved initially rather than spent. But there is some potential there to boost the consumer-spending numbers, at least for a few months, with noticeable effect. So it should make a difference in at least a couple of retail sales reports.