y Steven K. Beckner
Market News International - The Federal Reserve's policymaking Federal Open Market Committee gathers Tuesday amid high hopes -- hopes which, if disappointed, could wreak further havoc on Wall Street, some warn.
But the stock market is only one of the factors the FOMC will have to take into consideration in deciding the appropriate size of the next rate cut.
As the equities market crumbled last week expectations for further reduction in the federal funds rate zoomed beyond 50 basis points to 75 or even 100 basis points, whereas a week earlier, some were speculating that perhaps the FOMC might shift to a more incremental 25 basis point rate cutting pace.
Stocks and other asset values are important to the Fed, primarily because of their effect on household wealth and wellbeing, which in turn can influence demand. The loss of wealth incurred by investors over the recent period may well have diminished Fed expectations for the strength of consumer and business spending. And it has undoubtedly altered the Fed's sense of how supportive of growth overall financial conditions are.
But how much last week's market developments will change Fed thinking is hard to say. Various Fed studies of the "wealth effect" have yielded widely varying estimates of how much and how soon a change in the value of investment portfolios affect spending behavior.
Had equities not fallen to the extent they did over the past week or more, there were FOMC members who probably would have advocated a less aggressive rate cut Tuesday. Those voices are now apt to be more still.
That stock prices did plunge has undoubtedly raised the odds of a third 50 basis point rate cut, which would leave the funds rate at 5%. But what are the chances the FOMC will decide to do more? That will depend in large part on the extent to which the committee members judge that the stock market is reflecting or heralding more ominous overall trends.
Until the sell-off, Fed officials had sounded increasingly encouraged by the economy's growth prospects and were saying general financial conditions were fairly supportive of growth. And much of the recent economic and financial data seem to have borne out this sense of cautious optimism.
The heavy selling of stocks, which took the Dow Jones industrials below 9,900 and the Nasdaq below 1,900, seems to have been caused only partly by what is actually going on in the U.S. economy. Surely, investors' fears were driven to a large extent by earnings disappointments and warnings, lay-off announcements and weak-looking headline economic data. However, the stampede out of stocks was also driven by more tangential factors such as ongoing Japanese financial problems and European livestock diseases with only tenuous connections to the U.S. economic outlook.
Looking beyond investor fears, the anecdotal and statistical information which the FOMC will be reviewing suggests an economy that, while still struggling, does not seem to be sinking and may even be "flattening out," as St. Louis Fed President William Poole told Market News International two weeks ago.
The February employment report was not a rosy one, primarily because of the decline in hours worked, but it was hardly a recessionary report. The Labor Department reported that unemployment was unchanged at 4.2% in February instead of rising to 5.3% as anticipated. And nonfarm payrolls rose 135,000, down from January's 224,000 but far more than twice what had been forecast. Manufacturing employment declined a further 94,000 as companies continued to cut back production to work off excess inventories, but the service sector added 210,000 jobs, and there were also increases in construction payrolls. Even the 0.5% decline in the aggregate hours index had to be looked at in the context of the prior month's 0.8% rise.
The Fed has put more than the usual amount of weight on consumer confidence, and confidence has remained weak, even though it rebounded in March, according to the University of Michigan's latest reading. But whether or not people have jobs and whether or not their real incomes are rising are still considered more important in determining consumer spending.
Chicago Fed President Michael Moskow recently cited other reasons to be hopeful about consumer spending. First, he said, lower energy prices are likely to give consumers "more cash to spend on discretionary goods." Second, he said lower long-term interest rates should "free up cash for home improvements and similar types of spending" by spurring mortgage refinancing. What's more, he said continued productivity growth should keep real earnings rising.
Moskow, like Poole a voting member of the FOMC, also said "business spending should continue to hold firm" as companies take advantage of lower interest rates to make productivity-increasing investments. And he and others have spoken quite optimistically about a relatively speedy conclusion of the inventory correction.
The latest numbers on consumer spending looked disappointing, but on closer inspection were not all that bad. Retail sales fell 0.2% in February, despite increased sales of autos and other goods, but upward revisions to January and December sales cast a different light on the numbers, which in any case are notoriously subject to revision. The labor department now says January sales grew 1.3% in the first month of the year. Taking the first two months of the year together, Mickey Levy, chief economist for the Bank of America, estimates first quarter consumption growth approaching 3%.
A similar story can be told about housing. The latest numbers from the Commerce Department show housing starts dipping 0.4% in February, but that was not nearly as bad as expected, and it followed a 4.8 percent January jump. Building permits were down by 3.1%, but this followed a 14.4 percent surge the prior month.
February home sales have not been released as yet, but January sales were seen as pretty encouraging by Fed officials. New home sales were reported down 10.9% to a seasonally adjusted annual rate of 921,000 in January, but this followed a 14.9% December jump which Greenspan described as an "outlier." January sales were still up from the November level of 900,000. Meanwhile, existing home sales rose 3.8% in January.
With mortgage rates down nearly 130 basis points from a year ago, homebuilding and sales remained strong in March, according to the National Association of Homebuilders. The housing market index improved from 57 to 59 in March. The percentage of those who described new single family home sales conditions as "good" rose from 38% to 43% in March.
Poole observed that "if people were scared about the situation then you would see it showing up much more clearly in the aggregate consumption numbers and in home building and home sales." He was echoing a point made by Fed Chairman Alan Greenspan on Feb. 28. "For now, at least, the weakness in sales of motor vehicles and homes has been modest, suggesting that consumers have retained enough confidence to make longer-term commitments," he told Congress.
Manufacturing, of course, has been the most glaring area of weakness, but even here there have been glimmerings of a bottoming out, if not improvement. The Fed reported that industrial production fell a greater-than-expected 0.6% in February, and capacity utilization dropped from 80.1% to 79.4%. But manufacturing alone fell just 0.4%, two-tenths less than it fell in January and four-tenths less than in December. Production of motor vehicles and parts firmed, dipping just a tenth of a percent after falling 9.4% in January, and truck assemblies rose.
The figures seemingly confirmed the National Association of Purchasing Management's index of industrial activity increased for the first time since last September in February, though still contractionary.
In short, most of the economic data do not seem suggestive of what Greenspan might call a "cumulating" deterioration of economic activity, although it is a little early to be talking about an economic rebound.