As Recession Looms, Fed Faces Pressure to Cut More

Now that the US consumer has finally hit the wall, there’s growing speculation the Federal Reserve will push its interest rate pedal to the floor.

September’s 1.2 percent decline in retail sales and downward revisions in the two previous months virtually assure the first quarterly decline in consumer spending in 17 years. That's  something economists have been worrying about for some time, when it appeared the government’s fiscal stimulus package was having a limited effect.

“I've said since the summer that a ‘dark period’ of economic data lie ahead,” Miller & Tabak’s chief bond market analyst Tony Crescenzi told clients in a note.

Crescenzi is among the many economy watchers who now expect the government’s GDP data to show the economy contracted in the third-quarter. Economists expect that contraction to continue through the fourth quarter and into the first quarter of next year, which also bodes poorly for holiday sales.

“Housing has to bottom first,” says economist David Jones of DMJ Advisors. “So the recession doesn't end until March 2009 at the earliest, maybe even June 2009 at the latest.”

If so, it will be the longest – and perhaps the deepest—since the 1980-1982 period when the economy experienced a so-called double dip recession. Most economists expect the jobless rate—now at 6.1 percent—to easily surpass 7 percent in the months ahead. Some see an 8-percent  peak, sometime in 2009.

Richard Hastings, consumer strategist at Global Hunter Securities, is one of them.

“The sad reality is that it will take quite a long period for the consumer sector to recharge and that will in turn maintain pressure on financials,” says Hastings. “The ripple effects are already being felt in technology sector and will soon affect industrials."

For Investors

That’s the economic version of a vicious circle. The financial crisis feeds into the real economy and vice versa. Layoffs cool spending and depress prices, begetting more layoffs.

Though the latest producer price index data may have rang some initial inflation alarms, economists made little of the fact that core prices, which exclude autos and food, rose a greater-than-expected 0.4 percent in September.

“The handwriting is on the wall as the economy falls and oil prices plunge," said Robert Brusca, chief economist at FAO Economics. "It’s not a great report but nobody is going to be too worried about it. Other forces in train will serve to snuff out inflation. No point in obsessing over the PPI.”

Brusca and others say inflation is no longer a key factor and won’t get in the way of the Fed’s monetary policy, which now seems to favor interest rate cuts again. Brusca says a rate cut is likely between now and the end of the year.

Fed Chairman Ben Bernanke gave no hint of that in a speech Wednesday, saying that the central bank would "use all the tools at its disposal” to fight the financial crisis.

Some economists expect the central bank to cut its funds rate by a quarter or half point at its Oct 29th meeting, after taking it down to 1.50 percent with a half-point cut a week ago.

Brian Bethune, chief US economist at Global Insight, is among them. Bethune, however, says it may not stop there.

“The problem the Fed has now is the deflationary genie is out of the bottle,” says Bethune, who cites the collapse of the commercial paper market in mid-September as a key factor. Deflation is already here—in autos, houses, stocks.”

Bethune, for one, isn’t ruling out a federal funds rate below 1 percent, which would surpass the 2003-2004 low when the Fed openly admitted it was worried about the threat of deflation.

Others say the Fed won’t cut rates again, unless it absolutely has too.

Jones expects the fed to hold pat and try to stay there.

“I think 1 percent is one of those key levels that Fed officials would want to avoid at any cost,” says Jones, who says the European Central Bank’s rate cut last week helped the Fed policymakers.

Bernanke made a point of referring to the joint action Wednesday, as well as a litany of other steps and measures.

By one measure, real interest rates are already negative, because the funds rate -- even when it trades at its target—is below the annual rate of inflation as measured by the core PCE index.

Economists also say the Fed's strategy has moved beyond rate cuts because the financial crisis is less about liquidity than people originally thought. The Fed, they note, has also taken a wide range of extraordinary steps to lower the cost of money and to stimulate borrowing.

“I think that they gave us the 50 basis points the market really wanted in October,” says LakeView Asset Management President Scott Rothbort, who’s also a professor at Seton Hall University’s Stillman School of Business. “I think they did it begrudgingly.”

Another wild card is the presidential election on Nov. 4, just days after the FOMC's policy meeting and the release of third-quarter GDP.

"The Fed has historically tried to stay out of the way in election years," says John Irons, research director at the Economic Policy Institute. "They don't have that luxury right now."