Economic wind shifts; will Fed cut rates?

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Who would have thought that the meeting of a committee that sets interest rates would yield drama? But investors, economists and rate shoppers are eager to know what will happen when the Federal Reserve’s open market committee meets today.

Will the Fed cut short-term interest rates? Leave them alone? When the Fed assesses the economy, will it keep its smiley face or adopt a frown? Pundits and observers predict the whole range of options. An Op-Ed piece in the New York Times even argued for an interest-rate increase.

Some background: The open market committee meets eight times a year to discuss the economy and decide whether to raise or lower short-term interest rates or to leave them unchanged. At the end of each meeting, the committee explains its interest rate action with a statement saying whether the economy is running closer to inflation, recession, or right down the middle.

Usually, just days before the meeting, observers agree what the Fed will do and say. Not this time. To understand why, you have to review what has happened in the last six weeks.

The committee last met June 25 and 26. As expected, it kept the target federal funds rate at 1.75 percent. That’s the rate at which banks lend to one another overnight, and it influences other interest rates, most importantly the prime rate, which banks charge their best and biggest customers. Some types of consumer debt are based upon the prime rate.

The Fed’s June 26 statement called monetary policy “accommodative” — meaning interest rates are low and will have to rise eventually — and said “the risks are balanced” between inflation and a return to recession.

Picture the economy as a sailing ship with the Fed at the helm trying to steer the ship between the rock of recession and the reef of inflation. Shifting political winds and strong economic tides complicate the task. Back on June 26, the Fed implied that the ship was closer to grinding against recession than running into inflation.

What the Fed really said was “that economic activity is continuing to increase. However, both the upward impetus from the swing in inventory investment and the growth in final demand appear to have moderated.”

In other words, drifting just a tad toward recession, but no reason to lower the lifeboats. The Fed maintained its “accommodative” interest rate policy because it traditionally uses cheap credit as a tool to steer the economy away from recession.

Since that meeting and policy statement, the S&P 500 stock index has declined 17 percent. Other stock indexes have posted losses. Yields on 10-year Treasury notes have dropped more than half a percentage point.

More troubling, the Commerce Department reported that the gross domestic product rose at a rate of 1.1 percent from April through June, much lower than expected. The economy had grown at a rate of 5 percent in the first quarter, and economists had expected that momentum to carry into the second quarter.

Now some observers worry that the economy will drift into recession again, leading to predictions that the Fed will cut rates Tuesday or, at the latest, when the rate-setting committee meets Sept. 24.

Goldman, Sachs & Co.’s chief economist, William Dudley, predicts that the Fed will lower rates to 1 percent by year’s end.

Few others expect the Fed to act so aggressively. Futures markets have priced in the possibility of a rate cut. Traders at the Chicago Board of Trade have priced in about a 20 percent chance of a cut in the overnight rate to 1.5 percent at today’s meeting, and about a 38 percent chance of such a rate cut by the end of September.

Futures traders have priced in a near certainty of a rate cut by the end of November. Just two months ago, the same traders were fairly sure of a rate increase by the end of the year.

Other observers believe the Fed will stand pat on rates — that after cutting interest rates 11 times in 2001, the committee will leave them alone through 2002.

Richard DeKaser, chief economist for National City, predicts that the Fed’s next move will be a quarter-point rate increase in the first three months of 2003. He points out that consumers continue to spend and inflation remains tame.

“In our view,” he says, “businesses perceive the stock market to be signaling worse times ahead.”

But, he adds, those diminished expectations will be disproved.

Charles Lieberman, chief economist for Advisors Financial Center LLC, expresses a similar sentiment, but more forcefully:

“The economic news is better than is commonly portrayed,” he says, predicting “growth should improve in the second half.”

He points out that the economy has added jobs for three months in a row.

— Updated: Aug. 12, 2002