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The Fed May Have More Cutting to Do


Despite back-to-back quarters of positive—though paltry—growth, the U.S. economy remains shaky

After fighting fires in the financial system for the past nine months, Federal Reserve Chairman Ben Bernanke would dearly love to declare victory and put away the hoses. He's painfully aware that flooding the U.S. economy with money to prevent a financial meltdown and a severe economic recession raises the risk that he'll trigger a completely different problem: runaway inflation.

Unfortunately for Bernanke and the other rate-setters on the Federal Open Market Committee, the cut in the federal funds rate they announced on Apr. 30—a quarter-point, to 2%— probably won't be enough. Senior U.S. economist Paul Ashworth of London-based Capital Economics predicts the Fed will be forced to cut the funds rate to 1% by summer's end. The U.S. economy remains in dire need of aid, and the financial system, while no longer in flames as it seemed to be a couple months ago, is still smoldering. At the same time, inflation, aside from food and energy, is more a theoretical threat than a real one. Core prices rose just 2% from the first quarter of 2007 through the first quarter of 2008, going by the Fed's own favorite measure of inflation (the personal consumption expenditure deflator, excluding food and energy).

The Fed's distaste for further rate cuts was apparent in the statement it released with the Apr. 30 rate cut. The Fed seemed to indicate that it sees the risks of economic weakness and inflation as being equal. The presidents of the Dallas and Philadelphia Federal Reserve Banks balked at any cut at all.

In fact, though, the U.S. economy is weaker than is apparent from the 0.6% annual rate of growth in gross domestic product, which was reported before the Fed's statement. Much of the growth came from an accumulation of inventories—goods that were put on the shelf rather than sold. Final sales to domestic purchasers, which excludes inventory accumulation, actually fell 0.4%. It was the first such decline since 1991.

Indeed, the U.S. may well be in a recession despite the positive GDP report. First-quarter growth could be revised downward as more data come in. Even if the GDP news doesn't get worse, the business-cycle arbiters of the National Bureau of Economic Research could declare the current mess to be a recession in hindsight based on weakness in income, industrial production, and employment.

The good news, of course, is that the Fed's dramatic actions of recent months, such as helping finance the fire sale of troubled investment bank Bear Stearns, seem to have convinced investors that there's no longer much risk of a meltdown of the global financial system. Corporate bond issuance has picked up, and the Standard & Poor's 500-stock index has risen 10% since early March.

It's true, too, that many sectors of the economy are doing fine. By stimulating exports, the weak dollar is giving a lift to farmers, miners, and manufacturers. Procter & Gamble and General Motors both reported strong overseas earnings on Apr. 30. The health-care sector is cruising along as well.

JUSTIFIABLE FEARS

Other sectors, though, are desperately weak, in particular financial services and housing. Residential construction fell at an annual rate of 26.7% in the first quarter, the worst in 27 years. The number of vacant single-family homes and condos rose to nearly 2.3 million in the first quarter, a record. Consumer confidence is in the pits, hurting retailers.

And despite the efforts of Bernanke & Co., there's still plenty of stress in the financial system. Banks are charging one another a big premium over the fed funds rate for loans, reflected in the elevated London interbank offered rate. One reason: They're hoarding cash to guard against incurring more loan losses or being forced to take assets back onto their balance sheets, says Amitabh Arora, Lehman Brothers' global head of rates strategy.

The fear of more losses is justified. Contango Capital Advisors CEO George Feiger predicts that losses will soon spread beyond residential mortgages to commercial real-estate loans and then on to weaker parts of the corporate sector, such as companies that have undergone leveraged buyouts. And Feiger notes that banks suffering losses will be forced to cut back on new lending.

That's why the Fed may need to cut more. By reducing the federal funds rate, it can lower banks' borrowing costs so their profit margin on lending goes up. Retained profits will give them the capital base they need to lend more, juicing economic growth.

Inflation hawks worry that rate cuts will cause inflation to become entrenched. But the slow increase in the core rate of inflation over the past year shows that soaring food and energy prices have yet to spill over into the rest of the economy. In the case of energy, there's one obvious reason: Spending on gasoline depresses the economy by taking money out of consumers' wallets and sending it abroad. The same goes for imported food.

Another reason inflation continues to remain under control is that, contrary to appearances, the Fed has not pumped up the money supply to combat economic weakness. It has offset its new kinds of lending to commercial and investment banks by simultaneously draining money from the banking system. The core money supply, known as M1, grew just 0.2% in the year through March. And even at 2%, the fed funds rate is not highly stimulative, given that it's no lower than the year-over-year core inflation rate.

The Fed has quelled the panic that prevailed in the financial markets until recently. But it still has to nurse an economy weighed down by massive bad debts. That is likely to require a period of easier money. Don't put away those fire hoses quite yet.

Coy is BusinessWeek's Economics editor.

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