By Steven K. Beckner
Market News International - Unless the futures markets are dead wrong, the Federal Reserve's main policy instrument, the federal funds rate, is headed for its lowest level since May 1962 on Tuesday -- 2.50%.
The widespread expectation in financial markets is that the Fed's policymaking Federal Open Market Committee will cut the funds rate another 50 basis points for the second time in two weeks in an effort to prevent the terrorist attacks from sending an already struggling economy over the precipice into recession.
Even during the 1991-92 recession/credit crunch, the Fed never took the funds rate below its current level of 3%.
Not only would a 50 basis point rate cut take the funds rate to its lowest level in 39 years, it would push the rate below the rate of inflation. (In August, consumer prices were 2.7% higher than a year earlier).
That would mean a negative real interest rate, a place at which the Fed's critics allege it should have arrived before now. But the Fed had been reluctant to ease overly aggressively before the events of September 11, largely because Fed officials believed past monetary and fiscal stimulus was setting the stage for an economic recovery that would require them to reverse course in the not too distant future.
The Fed did not want to ease any more aggressively than necessary and then have more rate cuts to take back to avoid inflation. And so, beginning at the June 27 meeting and continuing at the Aug. 21 meeting, the Fed adopted a more incremental 25 basis point easing approach, following a series of five 50 basis point cuts.
Cautiously optimistic Fed forecasts always admitted the possibility of a negative external "shock" that could invalidate them. But, of course, Fed economists never anticipated the kind of shock that hit the nation on September 11th.
In the aftermath, the Fed essentially threw monetary caution to the wind, pumping massive amounts of liquidity into the financial system, well beyond what was needed to keep the funds rate at 3%. That rate has been allowed to float down to 2% at times. M2 money supply leaped a record $164.5 billion in the week ended Sept. 17.
All of this was done in spite of all the tax relief already in place before the attacks, despite more than $40 billion in emergency spending enacted after the attacks and despite the prospect of additional fiscal stimulus.
The Fed gave every indication at the time of its Sept. 17 intermeeting cut that more ease would be coming. Explaining the reduction of the funds rate from 3.5% to 3.0%, the Fed announcement said, "Even before the tragic events of last week, employment, production, and business spending remained weak, and last week's events have the potential to damp spending further."
Echoing past statements, the Fed added that "the long-term prospects for productivity growth and the economy remain favorable and should become evident once the unusual forces restraining demand abate."
But "for the foreseeable future," the Fed said, "the risks are weighted mainly toward conditions that may generate economic weakness." The statement also took the rare step of announcing that "the actual federal funds rate may be below its target on occasion in these unusual circumstances."
The few readings taken since the attacks are regarded as imperfect at best, but they do suggest further economic weakening. Both the Conference Board and University of Michigan measures of consumer confidence, based on only partial post-attack survey results, fell in September.
The National Association of Purchasing Management announced that its index of industrial activity, which had started to show some signs of improvement in August, slipped from 47.9 to 47, and NAPM's Norbert Ore acknowledged that it did not measure the full impact of the suicide bombings.
Employment conditions have, by all accounts, deteriorated significantly. Initial claims for unemployment benefits surged by 58,000 in the latest week to 450,000 -- highest level in nine years. Friday's Labor Department report is expected to show a further increase in unemployment from August's 4.9% rate.
And, of course, there have been massive losses of wealth in the stock market, notwithstanding last week's rally.
While many economists are still hopeful the United States will avoid anything more than a modest recession, there is near unanimity that the Fed will continue to ease aggressively, at least through Tuesday's meeting.
Richard Berner, chief U.S. economist for Morgan Stanley Dean Witter said he not only expects a 2.5% funds rate target, but said "we may continue to see deviations from the funds rate target." And he said he expects Tuesday afternoon's rate announcement to tilt toward yet further rate cuts by stating that "the risks are weighted toward weakness."
Berner said the August NAPM report suggested "a manufacturing economy that was trying to put in a bottom, and that may have extended into early September." But after the attacks, he said industrial activity "came to a virtual halt for a couple of days."
"My guess is you'll see a considerably weaker NAPM for October," said Berner, adding. "It's clear to me these shocks are going to push us into recession, at least through the end of this year and possibly into the first quarter."
The Bush administration is freely acknowledging the probability of recession. R. Glenn Hubbard, chairman of the president's Council of Economic Advisers, told Market News International last week that two quarters of negative GDP are "entirely likely."
First Union Senior Economist Mark Vitner said he is hopeful there will be only one quarter of negative GDP, but agreed there is "a 75% chance that they (of the FOMC) go 50 basis points."
"The manufacturing sector may have been bottoming out, but I don't think (the NAPM report) points to recovery," said Vitner. "It's hard to pick out a recovery" in the data. He also pointed to the 0.8% drop in consumer spending on durable goods included in the Commerce Department's report on personal income and personal consumption expenditures.
In recent years, inspired by the Japanese experience, there has been a good deal of discussion in Fed circles about the challenges of conducting monetary policy in a zero interest rate environment. Now the Fed unexpectedly finds itself drifting ever closer toward zero.
This has to give the Fed pause -- almost certainly not enough to discourage further easing to cope with the current crisis, but perhaps enough to make the Fed want to moderate its rate cuts after Tuesday's meeting -- if it can.
"I don't think (the zero interest rate barrier) is a real concern, but it's a factor that could temper the pace (of easing) going forward," said Berner.
"I wouldn't say the Fed is running out of ammunition, but at 2 1/2%, it may want to consider how much they have left," said Berner. But he added, "this is not a Japanese type situation, where the Fed needs to worry about going to zero."