Though there’s virtually no chance the Fed will change interest rates at its meeting next Tuesday, there’s a growing likelihood it will make subtle changes in the language of its policy statement, placing greater emphasis on the risks to growth than the threat of inflation.
And that may be the first step in a stunning policy reversal that could lead to yet another interest rate cut at the end of this year or early 2009, a move widely considered out of the question as little as a week ago.
With both the labor market and consumer spending behaving worse than expected and the economic growth of the second quarter likely to peter out sometime in the following two quarters, the Fed’s aggressive rate cutting earlier this year looks unlikely to achieve a soft landing.
The FOMC statement could “set the stage and give themselves some flexibility,” says veteran money manager James Awad, managing director of Zephyr Management. “I think they absolutely could” cut rates, particularly if things looked "dire" around the holiday shopping season.
It’s widely accepted that a good part of the Fed’s easing was directed at the credit crunch and that it expected more of a bounce from the government’s massive fiscal stimulus package of late February.
“There's powder left,” says Robert Brusca of the Fed’s monetary policy ammunition.
Though the dynamics of a presidential election arguably complicate the Fed’s policy choices this fall, the central bank’s close attention to labor market trends this year and in previous economic downturns suggest a rate cut can't be ruled out.
Jobs, Jobs, Jobs
“The monthly employment report has figured prominently into the Fed’s policy deliberations,” economist Christopher Rupkey of Bank of Tokyo-Mitsubishi said in a recent note to clients.
When December’s jobless rate spiked enough to qualify as a recession signal, Fed Chairman Ben Bernanke flagged the development in public statements and later stunned the markets with two rate cuts in a little more than a week. One of them was a rare three-quarters-of-a point move.
More recently, the August jobless rate surprised everyone, presumably even the Fed, in jumping from 5.7 percent to 6.1 percent; that’s well above the high end of the Fed’s range of 5.5-5.7 percent for 2008 and 5.3-5.8 for 2009 and the 4.4 percent low of the economic expansion.
What's more, weekly data show continuing unemployment claims rose 122,000 to 3.53 million in the week ended Aug. 30, the highest since October 2003. At the same time, payrolls have declined nine months in a row and are becoming more severe, as corporate layoffs escalate. Most economists expect the jobless rate’s ascent to continue into next year—perhaps even through all of 2009—peaking between 6.5 and 7.0 percent.
Though joblessness tends to continue to rise even after a recession has ended, few, if any, sectors point to growth. Even the booming trade sector is slowing, as the dollar’s recent appreciation kicks in and demand for exports slows along with overall growth in the economies of trading partners.
Some forecasts are also now calling for a contraction in GDP in the fourth quarter, and in some cases, occurring again in the first quarter of 2009.
Domestic demand is also weakening dramatically, despite the impact of the generous tax rebates of the stimulus package.
"Unless we have some sort of miraculous bounce in spending in August and September, we're going to have the first decline in consumer spending in 17 years [on a quarterly basis]," says David Resler, chief economist at Nomura International. "Most of the fiscal stimulus went to paying for higher gasoline prices.”
The government Friday said retail sales punged 0.3 percent in August and 0.7 percent excluding autos. Though that partly reflects the drop in gasoline prices, the reading is still weak. July's decline was revised lower from 0.1 percent to 0.5 percent.
"A de-acceleration in consumer spending is bad news for jobs; the causality is pretty direct," says Nariman Behravesh, chief economist at Global Insight, who sees a 40 percent chance of a Fed cut, most likely in December.
What's Worrying The Fed
In its August minutes, the Fed’s FOMC cites flat real disposable income – one of the four conventional recession indicators—and a weaker outlook for consumer demand.
And though the committee’s focus had clearly moved to the threat of recession, the minutes indicate most members “did not see the current stance of policy as being particularly stimulative.”
In addition, two of the hurdles to a future rate cut have been lowered if not removed altogether.
At about $100 a barrel, crude oil prices are down by a third from their record high of $147.27 on July 11, while the dollar has risen 11 percent from its record low of this year.
That combination of events “gives them some breathing space,” says Brusca, chief economist at Fact & Opinion Economics.
Still, there’s sufficient uncertainty to gave the Fed pause.
Awad says the Fed would want to make sure the “break in commodities and the break in oil” is a longer-term trend before dismissing the inflationary aspect of a rate cut. That may not be possible until the onset of the home heating oil season in late October or early November.
The Fed may also want to see how the Fannie Mae-Freddie Mac takeover plays out in the mortgage market. Interest rate spreads — though narrower in the wake of the federal action—still remain historically wide, despite the Fed’s monetary medicine. Should spreads remain wide, the Fed could be forced to act.
Timing Is Everything
All of this—as well as the timeline of the Fed’s meeting schedule and the election calendar—suggests that if a rate cut is in the cards it would be late in the year, most like mid to late December.
As recently as Tuesday, the December interest rate futures contract showed a 25% chance the central bank will reduce rates to 1.75% at its meeting that month.
After the Sept. 16 meeting, the next one comes Oct. 28-29, less than a week before the general election, probably too soon in the economic cycle as well as too close to the election itself to recommend any drastic action.
The Fed does not meet again until Dec. 16, by which time the verdict on the holiday shopping season may be in (Awad’s point), as well as two more months of labor market data and all three readings of third-quarter GDP, the first of which comes Oct. 30, right after the FOMC meeting.
The first meeting of 2009 doesn’t come until Jan. 27-28, a week after the new president’s inauguration and start of a new Congress, which may be too late for anyone’s taste, especially if a new stimulus package is on the agenda.
Rupkey says it is extremely unlikely the Fed will cut rates any time soon. “If payrolls start declining 200,000 a month, then its possible,” he says, or if “payrolls are still declining seven-eight months from now, then they'll be under pressure to cut rates.”
That or another event posing systemic risk. The Bear Stearns rescue is one such case and the Fed cut rates 75 basis points around that time. The takeover ofFannie Mae and Freddie Macapparently was not. The fate of Lehman Brothers remains to be seen, but it begs the question of whether it falls into that category.