Magazine

U.S.: The Fed's New Worry: Irrational Pessimism


Two years ago, the Federal Reserve raised interest rates in an attempt to slow the red-hot economy. One goal was to deflate the stock market and wring the wealth effect out of consumer spending. The problem for 2001 is that the Fed may have succeeded all too well. Stock prices are sinking at a time when portfolio performance drives household sentiment and spending like never before. As a result, policymakers are being forced to act in an unusually swift and bold manner.

The state of the economy and monetary policy was the focus of Fed Chairman Alan Greenspan's Feb. 28 talk to the House of Representatives. His appearance was the second leg of what was formerly known as the Humphrey-Hawkins testimony, and in the past Greenspan has repeated the same speech to both chambers. But in this latest iteration of Fed man talking, the chairman updated his speech, and he sounded slightly more downbeat than he had just two weeks earlier.

Greenspan said that the exceptional degree of slowing evident at the end of 2000 was less evident in early 2001. Nonetheless, he cautioned that even after two interest-rate cuts in January, "the risks continue skewed toward the economy's remaining on a path inconsistent with satisfactory economic performance." This view raised the probability of another half-point cut at the Mar. 20 meeting, but it showed no urgency for an intermeeting move.

The latest data underscore a cautious, but not panicky, view of the economy. Durable-goods orders and new-home sales both tumbled in January, and consumer confidence in February fell to its lowest level in 4 1/2 years (chart). But other data, such as a jump in the leading index, seem more positive for the outlook.

GREENSPAN ENDED HIS SPEECH by noting that the slowdown in demand and the resulting need to adjust inventories "has yet to run its full course." That idea was supported by the Commerce Dept.'s revision to real gross domestic product. It suggests that the need to draw down excess inventories is still hurting U.S. manufacturing in the first quarter.

Commerce said that real GDP grew at a 1.1% annual rate in the fourth quarter, a bit less than the 1.4% originally reported. Economists had expected a bigger downward revision, led by a much smaller accumulation of inventories. Instead, inventory growth eased, but not by much (chart). With demand still cool, that yearend stockpiling means that more of the inventory adjustment must take place in this quarter.

The chairman reiterated that the Fed remains ready to respond quickly to the economy's needs. Given that, policymakers must be bothered that their aggressive actions so far this year have not boosted consumer spirits. The Conference Board's February index of consumer confidence fell to 106.8. In the past two months, the index has plunged almost 22 points, the biggest two-month drop since the 1990-91 recession. If consumers continue to feel nervous about the future, they could cut back drastically on their spending and topple the economy into recession.

WHAT'S BEHIND THE BLUES? First, consumers express more worry about the future than they do about current economic conditions. The index of expectations for business conditions, employment, and incomes fell to its lowest level since 1993 and is off some 42% from its peak in January, 2000. But households' rating of the present situation has declined only 12% from its June peak. This reading is about where it was in early 1998, when economic conditions were very good.

Certainly, the wave of layoff announcements is causing concern about the future. The board reported that 12.9% of people now think jobs are hard to get, but that is up only a bit in recent months. Despite the layoff reports, the labor markets still remain fairly tight. The January employment report was strong, and new claims for jobless benefits are nowhere near recession levels and have stopped rising in recent weeks.

Most important, the Fed cannot ignore that households are also responding to the steady decline in the stock markets, especially the once high-flying Nasdaq. The Nasdaq has fallen 56% from its March, 2000, peak, and the broad Wilshire 5000 is off 22%. Given that half of U.S. households own stock in some form, is it any surprise that confidence has dropped 22.1% over the same time period? Greenspan said the stock market, through the wealth effect, was a "prominent factor" in economic growth since 1995, adding: "Clearly with the market reversing, that process does indeed reverse."

The market's influence on sentiment and spending, however, is causing headaches at the Fed. Policymakers do not want to be seen as "bailing out" Wall Street. Yet unless the stock market stops falling, Greenspan could find himself blamed for another recession.

BUT IS THE U.S. truly headed for a downturn? As it stands now, there is no sweeping evidence, outside of the stock market hazard, that the expansion is at risk. Close examination of the latest data on home sales and durable goods shows that those sectors are not as weak as the headline numbers show. For instance, sales of new single-family homes plunged 10.9%. But sales in December jumped 14.9% to a postwar record of 1.03 million. The January level of 921,000 was higher than the average for all of last year.

As for hardgoods orders, almost all of January's 6% plunge reflected a 22.4% drop in transportation equipment. Some of that was autos, but most was a 49% drop in aircraft bookings, which are very erratic.

Excluding planes, orders for nondefense capital goods rose 6.5% in January. That was the largest gain since June and reversed a three-month slide (chart). Although orders for electronic components, mainly semiconductors, fell, bookings for industrial equipment jumped, led by orders for computers and office equipment. That's good news for future capital spending.

Moreover, the leading index is veering away from its danger zone. The Conference Board's composite index of 10 leading indicators, designed to foreshadow the economy's trends, had fallen in the three months ended in December. But in January, the index jumped 0.8%.

At yearend, the index was nearing the crucial 3.5% annual rate of decline over a six-month period that has always signaled a recession. Now, the pace of decline is a much less worrisome 0.7%. Some of the January jump was weather-related, but weather also affected some of the December data in the opposite direction.

All these hopeful signs for the outlook, however, may mean nothing if the stock market continues to sink, dragging confidence and demand down with it. Unwittingly or not, Greenspan & Co. now find policy facing an old Chinese proverb: Be careful what you wish for. You may get it. The Fed has met its goal of deflating the market bubble, but its success has heightened the risk that consumers will drag the expansion under. By James C. Cooper & Kathleen Madigan


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