Fed Cuts by a Quarter-Point

Bernanke drives rates to the lowest since '04 after GDP shows weak growth built on inventories

by Peter Coy

Is the U.S. in a recession? Probably so, although you wouldn't know it from two key announcements on Apr. 30 by the Commerce Dept. and the Federal Reserve.

In a split decision, the Federal Reserve cut its key interest rate again. It said that "economic activity remains weak," but added that its measures "should help to promote moderate growth over time." The action came hours after the Commerce Dept. reported that gross domestic product grew in the first quarter. The increase was a meager 0.6%, the same as in the fourth quarter of 2007, but it was still above zero.

Economists sifted the Fed's statement for hints of whether the Fed was done cutting but there were no obvious clues, indicating that the Fed doesn't want to paint itself into a corner on future actions.

With the quarter-percentage-point cut in the federal funds rate—to 2%, its lowest rate since December, 2004—"the Fed is buying extra insurance against a deeper recession," said Arun Raha, senior economist for Swiss Re, in a statement released minutes after the Fed's 2:15 p.m. Eastern time announcement.

The Fed steered clear of any mention of recession. It said, "Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters." On inflation, the Fed said it "expects inflation to moderate in coming quarters."

Domestic Consumption Falls

The decision was split because two voters on the Federal Open Market Committee—Dallas Fed President Richard Fisher and Philadelphia Fed President Charles Plosser—"preferred no change in the target for the federal funds rate at this meeting." As usual, the Fed cut the discount rate by an equal amount, to 2.25%.

The GDP report, showing a 0.6% annualized rate of growth in the first three months of 2008, probably overstated the actual health of the economy. On closer scrutiny, the report shows the most weakness in 17 years in actual domestic demand for goods and services. That means the pressure is still on the Federal Reserve to keep cutting interest rates.

All of the meager growth was accounted for by a pileup of inventories. In other words, the economy produced a lot of stuff that went onto the shelf because of insufficient demand. The measure that shows the actual consumption of goods and services within the domestic economy fell at an annual rate of 0.4%, the first decline since the fourth quarter of 1991. That crucial indicator—"real final sales to domestic purchasers"—did not fall at all in the 2001 recession.

There was a bit of good news on the inflation front. The measure of inflation that the Federal Reserve heeds the most rose at an annual rate of 2.2% in the first quarter, down from 2.5% in the fourth. That's only a tad above the top of the Fed's comfort range for that inflation measure, namely 1% to 2%. (That measure excludes food and energy, which tend to fluctuate a lot. Including food and energy, the GDP inflation measure rose at a 3.5% pace.)

Business Investment Weak

In a separate report, the Labor Dept. said on Apr. 30 that employment compensation for civilians, which covers both wages and benefits, rose 0.7% in the first quarter, the smallest increase in two years. That comes out to an annualized rate of just under 3%.

Stock prices rose in early trading after the premarket-opening release of the GDP report, perhaps in relief that the headline number for GDP growth came in roughly in line with expectations. The Dow Jones industrial average was up 84 to 12,916 as of 11 a.m. But the market's reaction is no assurance that the report was actually strong. "There are some very troubling signs in this report," wrote Paul Ashworth, who follows the U.S. economy for London-based Capital Economics. Ashworth noted that inventory accumulation alone added 0.8 percentage points to first-quarter growth.