For the Fed's next trick...
January 3, 2002: 5:25 p.m. ET
After record rate cuts, Fed-watchers study a glass half full -- or empty.
By Staff Writer Mark Gongloff
NEW YORK (CNN/Money) - A year ago to the day, the Federal Reserve launched the most aggressive one-year rate-cutting campaign in history in an effort to keep the United States economy from running aground.|
Many economists grumble that the Fed was just desperately trying to correct its own error, as they perceive it -- namely, six rate hikes in 1999 and 2000. Almost all agree that the central bank's 11 cuts in 2001 softened the blow of recession and the Sept. 11 terror attacks.
But economists are less clear about the course the Fed will set as it tries to steer the world's largest economy through what promises to be a difficult 2002.
The inflation busters
A majority of prognosticators say the economy is already on the mend. That's the good news. But these so-called inflation "hawks" also say that the rate cuts and billions of dollars pumped into the economy by the federal government, via tax cuts and Sept. 11 relief, will eventually fuel rising prices and wages if the Fed doesn't pull in the reins this year.
"There's so much liquidity in the economy right now that, left alone, it could become fuel for inflation," said Sung Won Sohn, chief economist at Wells Fargo & Co. "I can see the Fed taking preventive measures to ensure inflation doesn't become a problem."
Stock prices seem to be predicting an impending economic recovery, but bond yields have crept upward in recent weeks to keep up with expected inflation.
Implied yields on federal funds futures contracts -- often accurate predictors of what the Fed will do with rates -- anticipate the Fed will leave its target for the federal funds rate unchanged at 1.75 percent at its Jan. 29-30 policy meeting and could add half a percentage point to that target by August.
"Once the Fed starts raising rates, I suspect they might go up more rapidly than a lot of people realize," Sohn said. "Many of us think the Fed will do things slowly and gradually. In fact, they usually do things pretty quickly."
The ever-resilient consumer will likely lead the recovery and force the Fed's hand, many of these hawks think.
Consumer spending fuels two-thirds of gross domestic product, the broadest measure of the U.S. economy. It was frozen in the weeks after Sept. 11, and consumer confidence in the economy plummeted as GDP shrank and economists declared a recession had begun in March.
But spending recovered from its initial shock, and confidence surged in December despite mounting job cuts and an unemployment rate creeping to 6 percent and beyond.
"Households understand things before businesses do, and unemployment is a lagging indicator for that reason," said Joel Naroff, president of Naroff Economic Advisors and chief economist for Commerce Bancorp. "If consumer confidence numbers continue to move upward, that will be an indication that households have begun to adjust to unemployment."
And 6 percent unemployment is not exactly the end of the world anyway, these economists point out, especially considering the fact that unemployment hit 10.8 percent after the 1981-82 recession and 7.8 percent after the 1990-1991 recession.
"Five years ago, people thought 6 percent unemployment was darn well getting to full employment," Naroff said. "Even if hits 6 percent, we still have 94 percent of the labor force working."
The vocal minority
But a vocal, conservative minority is not so bullish on the economy and definitely not hawkish about inflation. This group predicts that rates will stay the same in 2002, or may even go lower.
"The Fed's raising rates is highly doubtful," said Lacy Hunt, chief economist at Hoisington Investment Management and a former Fed economist. "The road to recovery will be very difficult and very uncertain. Inflation will continue working its way lower."
Inflation never made an appearance in 2001, when the economy was in recession. If weakness -- even weak growth -- continues in 2002, consumers will curtail their spending, and businesses will have little ability to raise prices, cautions Hunt and those who agree with him.
"In a typical recession, you see people...consolidate their domestic balance sheets," said Brown Brothers Harriman economist Lara Rhame, formerly a Fed economist. "Instead, spending [has been] as robust as before, and that's hurt domestic balance sheets. We're really at a point where the consumer is squeezing water out of a stone. It doesn't provide the ground for a robust recovery."
Businesses could also be slow to start spending again, further slackening inflation pressure. With factories running at just 74.7 percent of capacity in November, according to a recent Fed report, there's not much incentive to buy more plant equipment.
That excess capacity and the unsold goods sitting on manufacturers' shelves are the residue of the investment boom of the late 1990s and early 2000, when the Fed tried to cool growth by raising rates. When the boom went bust, businesses stopped spending on technology and other equipment, manufacturing entered a 17-month-long recession and more than a million workers lost their jobs.
Though inventories are finally being sold off, production will not pick up again until demand recovers, and ongoing job cuts could continue for some time as businesses try to bring costs in line and boost profits after two straight years of falling stock prices.
"One of the consequences of excess capacity is that there will be additional layoffs," said former Fed economist Hunt. "And many of the jobs we're losing are higher-paying than those that are being added, resulting in a loss of purchasing power."
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While most economists expect GDP growth this year, few of them expect robust growth. If it's not healthy enough to support the ever-expanding work force, then the country could experience a "growth recession," last seen in 1991-92.
"When we came out of the recession in March of 1991, GDP started rising very feebly, while the unemployment rate continued rising for another year and a half," Hunt said. "The press called it a 'jobless recovery,' and it was one of the reasons [President Bill] Clinton was able to defeat former President [George] Bush. The average person on the street judges the economy by the job market."
If consumers react by finally paying off their debt instead of spending -- and there's a limit to how many zero-percent-financed cars most families can buy -- then the Fed might be more inclined to keep rates stable, or even lower them some more.
History also supports the notion of the Fed keeping rates low during a recovery, according to data compiled by Brown Brothers Harriman economist Rhame. In fact, the Fed kept cutting rates for more than a year after the last recession, not stopping until Sept. 1992, when the recession was long over.
"I'm not presuming they'll be aggressively cutting rates [this year] if we see data turning around," Rhame said. "But traditionally, the Fed holds rates low for a year and a half after a recession, and usually continues to cut throughout the beginning of a recovery."
"When [consumers] shift their income stream from purchases to saving, it slows GDP, and that's a long-term process," Hunt said. "I think interest rates are going to remain very low for a couple of years."