Sunday, January 7, 2001
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Posted on: Sunday, January 7, 2001

Rate cut may have darker side

By Dina Temple-Raston and George Hager
USA Today

Ray Stone, economist at Stone & McCarthy Research Associates, was in his Princeton, N.J., office talking on the phone about currency rates last Wednesday when the news crossed the wire.

Daniel Burke offers a sale during active trading Wednesday at the Chicago Mercantile Exchange after the the Federal Reserve decided to drop a key interest rate by half a percentage point.

Associated Press

"Oh my God! The Fed cut rates, the Fed cut rates," he shouted, blinking in disbelief.

Stone wasn’t alone. No one saw the Federal Reserve’s half-point rate cut coming.

And while investors initially were positively giddy, cheering as they drove up stock prices, some economists found themselves swallowing hard.

Has the Fed seen something particularly disturbing in the economy that no one else has divined? And if there is something as sinister as a recession on the horizon, has the Fed acted in time or is it already too late?

Despite the euphoria, economists fret there could be a darker side to the Fed’s decision to cut between its scheduled meetings.

"For the Fed to cut between meetings, you’ve got to be wondering, what are they seeing that we don’t?" says Christopher Wolfe of J.P. Morgan.

Only as recently as at its Dec. 19 meeting, the Fed decided to leave rates unchanged, saying it would keep watch to make sure that the economy didn’t slow too much. It said, for the first time since September 1998, that glacial growth was more of a threat to the economy than inflation.

"Maybe there is something going on that we don’t know about, and there’s another shoe to drop," says Michael Reynnells, economist at International Strategy & Investment. "Usually, more extreme situations call for moves in between Fed meetings. We didn’t think they would do this in absence of a crisis."

Does Fed see recession?

Other economists were also troubled by the Fed’s decision to act before its next meeting, Jan. 30-31.

Steve Roach, chief economist at Morgan Stanley Dean Witter, was downright gloomy. Though he had already forecast the economy will grow a rather lackluster 1 percent for the first half of this year, he is preparing to downgrade his projections further.

"The risk of recession is high and rising from our earlier forecast," he says. "Do you want to know what the Fed sees? I think the Fed sees recession."

Broadly, a recession is defined as two consecutive quarters of a shrinking economy. So far, there hasn’t been even one quarter of such a decline in the nation’s output of goods and services.

What there has been, though, is a dramatic slowdown in an economy that had been the envy of the world. The economy grew 5.6 percent in the second quarter of last year, and then slowed to less than half that pace in the third quarter. The government will release the fourth-quarter figures at the end of the month.

If Fed policy-makers have already spied the telltale signs of an economy in decline, analysts say, then the party is already over and consumers ought to brace themselves for a rough ride.

They aren’t being extremist, just realistic. Interest rate cuts don’t work overnight.

In fact, it usually takes six months to nine months for the full effect of any monetary policy — interest rate increases or decreases — to work through the economy. That means if we’re already on a recessionary track, then Wednesday’s move could be too little, too late.

Bill Crutchfield, founder and CEO of Crutchfield of Charlottesville, Va., a leading mail order and Internet retailer of consumer electronic goods, greeted the Fed action with relief, though he thinks it may not be enough.

"I have never seen an economy decelerate as quickly as this one has," he says, adding that his sales went flat last month. The economy "really seemed to hit a wall in December, and I think the Fed saw that and realized they had to do something."

Warning signs

Until now, Fed Chairman Alan Greenspan has shown he is nothing if not a master of timing, able to raise or lower interest rates to sustain the nation’s longest unbroken run of economic growth. What is unclear is whether he misjudged this time and the economy has already faltered. Wednesday’s move can’t reverse a lackluster holiday shopping season, dismal earnings reports or rotten December car sales.

"This cut is too late to forestall a recession, but not too late to limit its severity and its length," says Roach, who is more pessimistic than most analysts. "The fact that the Fed moved between meetings clearly shows there is a sense of urgency."

To be sure, the economy was already looking pretty ugly. Among the warning signs:

The consumer confidence index, which had been breaking records most of last year, dropped to its lowest point in two years last month, battered by rising energy prices and crumbling stock portfolios.

Industrial production fell in October and November, the first two-month decline since mid-1998, with automakers warning of falling profits and layoffs. General Motors announced Wednesday that new car and truck sales fell 18 percent in December.

Similarly, Ford Motor, the No. 2 automaker, said that its total U.S. vehicle sales tumbled 14.1 percent in December to 275,756 cars and trucks. That’s down from record levels last year.

Gross domestic product, which rose at a 5.6 percent annual rate in the second quarter, expanded at a 2.2 percent pace in the third quarter, the slowest pace in four years.

Retail sales fell in November, the first monthly decline in seven months, and holiday sales disappointed many retailers. Personal computer sales in the retail and mail-order market, for example, declined by about 24 percent in December from a year ago, the largest year-to-year decline ever, according to preliminary results released Wednesday by research firm PC Data.

The danger signs started emerging last fall, as Intel, Microsoft, Dell Computer and other tech giants issued earnings warnings and cautioned that European and possibly global sales were slowing. "We’re watching the economy closely," Intel CFO Andy Bryant told Wall Street analysts during a conference call.

Corporate spending on technology has also been dipping, and business customers are canceling orders in the United States and worldwide. That’s forcing scores of high-tech firms to scale down their sales forecasts for 2001. After several years of torrid 30 percent to 60 percent annual growth, computer, semiconductor and networking-equipment makers anticipate growth this year in the low to high teens.

In shopping malls nationwide, wary consumers aren’t snapping up high-tech toys as quickly as before. Inventories of PCs are backlogged up to two to three months, and Apple Computer on Tuesday cut the prices on its PCs from $300 to $1,000, with other PC firms expected to follow suit.

The last straw for the Fed, however, may have come Tuesday, when the National Association of Purchasing Management announced that its monthly index of factory activity plunged from 47.7 in November to 43.7 in December, the sharpest one-month drop in more than five years and the weakest monthly reading since the nation was emerging from recession in April 1991.

"Clearly the NAPM report was the trigger," says Louis Crandall, chief economist for Wrightson Associates and a longtime Fed watcher. "If the Fed is trying to decide whether it’s appropriate to start undoing some of its earlier rate increases, getting a recessionlike reading out of one of Chairman Greenspan’s favorite indicators has to tilt the odds."

Confidence crucial

President-elect Bush, hosting an economic summit with CEOs in Austin, Texas, applauded the Fed’s action. "I think the cut was needed," he said, adding that he thought it showed that the Fed was "mindful" of the "warning signs" in the economy.

Bush said that business leaders gave him "bad news" about lagging sales and potential job layoffs during the Austin summit. He said that he received no advance warning of the Fed interest rate cut.

Expectations and the perceptions of business leaders may be crucial to the Fed’s success. If CEOs are willing to invest, then the economy will keep humming. Recently, their confidence appeared to be waning. In their earnings announcements, many were talking about cutting back on capital spending.

"You could sense the people who run companies are beginning to lose confidence," says David Orr, chief economist at First Union. "The Fed is trying to reassure leaders that if they make those investments, the economy will stay on an even keel."

The rate cut will also help in another way: it loosens credit. One of the triggers for recession is overly tight credit markets, and lowering interest rates immediately improves bank profits and gives them some cushion against losses, Orr says.

Edward Iwata and Adam Shell of USA Today contributed to this story.

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