As expected, the Federal Reserve left interest rates unchanged at its Sept. 24 policy meeting. The move was greeted with disappointment in the stock market, since some investors had nursed hopes that the Fed would take pity on them and cut rates.
But the Fed is not playing to Wall Street. It's the business sector that the Fed is focused on right now. Overall demand, especially by consumers, has strengthened recently. But until businesses shake off their uncertainty and their hesitancy to invest and hire, the recovery cannot be self-sustaining. That means the Fed will be willing to keep policy very accommodative, perhaps far into 2003.
Moreover, the chance of a rate cut appears to have risen. Two of the Fed's policy-committee members actually dissented from the decision, preferring an immediate rate cut. The unusual departure from consensus indicates how concerned policymakers are about the economy's prospects. And if the business sector's malaise causes growth to falter, a rate cut for the sake of recovery insurance will be an even hotter topic at the Fed's Nov. 6 meeting.
In its decision to hold the target rate for overnight federal funds at 1.75%, the Fed sounded more upbeat about overall demand than it did at the August meeting. It was also sanguine about the economy's prospects in light of strong productivity growth and the stimulus provided by the current accommodative policy stance.
But the policymakers expressed concern about "the extent and timing of the expected pickup in production and employment owing in part to the emergence of heightened geopolitical risks," obviously a reference to corporate worries about war with Iraq. As a result, the Fed reiterated that the balance of risks in the outlook remain skewed toward economic weakness.
THE FED'S WORRIES are understandable given the recent soft economic data (charts). The index of leading indicators fell 0.2% in August, the third consecutive drop. Housing starts have also slipped for three months. And household confidence for September fell again as consumers remain wary of job prospects and war.
Despite those bad numbers, the recovery remains on track, thanks in large part to resilient consumer spending. Real gross domestic product probably grew at an annual rate of about 4% in the third quarter. That means growth over the past year averaged above 3%, or close to the economy's long-run, sustainable pace. That strength is a big reason why the Fed held rates steady.
But the Fed is well aware that economic growth is extremely uneven. Businesses remain too uncertain about the future to act on spending projects or hiring plans. That's why Fed policy decisions in coming quarters will be determined more by conditions in the business sector than by consumer fundamentals such as confidence or the jobless rate.
TARGETING THE BUSINESS SECTOR is crucial at this juncture, because if business spending does not pick up soon, the recovery is at risk of fizzling out. Any slump would not be a continuation of last year's recession, but rather a new wave of weakness caused by several factors that came to a head this year. First, the corporate scandals rattled the stock market and wiped away $1.2 trillion in household wealth this year. Second, the war talk has injected further risks into the outlook, especially concerning the future of oil prices.
Lastly, financial institutions have gotten burned from the accounting scandals and bad loans. So their lending practices may tighten--making it costlier for businesses to fund capital projects. Unless these trends reverse and businesses become more confident, the economy's momentum could peter out by the start of 2003.
In addition to looking for uncertainty to ease, the Fed also will be watching for an uptick in pricing power. That may seem counterintuitive for the Fed, because it could mean more inflation. But, as policymakers have pointed out, the healthy outlook for productivity means inflation shouldn't be a problem anytime soon. In fact, if the economy grew by 4% in the third quarter, output per hour worked would have jumped by 5%, and unit labor costs would have fallen by at least 2%.
In the past, Fed Chairman Alan Greenspan has indicated that better pricing power is a key ingredient to boosting profits and lifting capital spending. In an April speech, Greenspan said: "To the extent that businesses are successful in boosting profits and cash flow, capital spending should begin to recover more noticeably." That's why the Fed will be watching the trend in capital goods orders to see if businesses are beginning to pump up their investments in new equipment again.
UNLESS BUSINESS SPENDING KICKS IN, the economy will be far weaker in the fourth quarter than it was in the third quarter. The dip in September confidence and softness in weekly store surveys in mid-September indicate consumers may have headed into the fourth quarter with less energy than they showed in the third quarter, when real consumer spending probably grew at an annual rate of at least 4%.
Most of that surge came early in the quarter. By September, consumers turned more cautious. The Conference Board reported that its index of consumer confidence fell to 93.3 from August's 94.5. All of the drop came in households' assessments of current economic conditions, which fell to an 8-year low. Expectations for six months ahead rose slightly. The board said "weak labor market conditions continue to erode confidence." New claims for unemployment benefits have been rising since early August (chart).
It's too early to tell if shoppers are making a lasting shift in their spending or just taking a breather. Clearly, the record pace of mortgage refinancings means that many homeowners will have more cash to spend in coming months, either by lowering their monthly payments or by taking some equity out of their homes. And many workers are still getting pay raises that exceed the inflation rate. Real disposable income is running about 5% ahead of its year-ago pace.
The healthy gains in income, coupled with low mortgage rates, continue to buoy the housing industry. Although housing starts slipped 2.2% in August, to an annual rate of 1.61 million, builders report that sales and buyer traffic picked up in September. They also expect sales to increase further in the future.
The builders' outlook sounds a recurring refrain for this recovery. Housing and consumer spending remain the driving forces for growth. But the Fed wants to see a more balanced upturn. That's the only way to ensure this recovery has legs to carry it through 2003. Business executives must shake off their paralysis and start making new investments in equipment, restocking inventories, and freeing up hiring plans. Until that happens, expect the Fed to continue its very accommodative monetary policy. By James C. Cooper & Kathleen Madigan