Is the Fed Coming to the Rescue?

The economy is drifting very close to the edge now and what would have taken a gale force wind a few months ago might well be accomplished with little more than a wisp now. You might remember that in last weeks’ Brief we posed the question as to whether the Fed had lowered rates enough to sustain economic expansion. We noted that future reductions might be constrained because of growing threats of inflation as well as a dramatically sinking dollar. But without them, we noted the odds were greater that the economy would falter. The past several weeks’ revelations of worsening banking and credit problems, combined with a host of economic releases showing deterioration have changed the tone of the Fed dramatically.

In Charlotte last night, Federal Reserve Chairman Ben S. Bernanke said volatility in credit markets has “affected” the economy’s prospects and policy makers must decide whether the risks between growth and inflation have now shifted. “The outlook has also been importantly affected over the past month by renewed turbulence in financial markets. The committee will have to judge whether the outlook for the economy or the balance of risks has shifted materially.” He added that uncertainty around the outlook is “even greater than usual,” requiring the Fed to be “exceptionally alert and flexible.” 

Yesterday, Vice Chairman Donald Kohn all but stated the Fed was prepared to lower rates a third time at their meeting Dec. 11th. Fed funds futures now indicate a 100% chance of a reduction in the benchmark rate next month, with a 30% probability of a half-point move, according to Bloomberg. Neither Bernanke nor Kohn used the language of last month’s FOMC meeting that stated that the risks between growth and inflation were “roughly” balanced. 

On Monday there was hope that the consumer was still fully engaged as results showed that sales on the two days following Thanksgiving were up 7% over last year. But as the week wore on and the data poured in, it seemed little more than a last gasp. The Commerce Department reported today that consumer spending rose less than forecast in October with only a 0.2% increase in purchases following a 0.3% gain in September. Bernanke said last night that “the combination of higher gas prices, the weak housing market, tighter credit conditions, and declines in stock prices seem likely to create some headwinds for the consumer in the months ahead. Continued good performance by the labor market is important for maintaining the economic expansion.” 

Yesterday the Labor Department reported that the number of Americans filing first-time claims for unemployment benefits rose more than expected to the highest level in nine months. Initial jobless claims increased by 23,000 to 352,000 in the week that ended Nov. 24th, the most since February. The number of people staying on benefit rolls was the highest in almost two years. 

In past months, job and income growth have countered the headwinds of higher gasoline prices and declining home values. However, recent increases of gasoline and the continued drumbeat of falling house values and tighter credit may serve to finally overwhelm the incredibly resilient consumer. News like that released on Tuesday revealing that home prices in theUSfell 4.5% in the third quarter, the most in at least two decades. On Wednesday the bad new continued that sales of previously owned homes fell in October to the lowest level in at least eight years. Sales were down 20.7% from October 2006 and the drop of 4.5% in median home price declined was the most on record. 

Other news this week suggests that the economy’s woes may exceed those of the consumer. Orders for US durable goods fell more than forecast in October, perhaps signaling companies are losing confidence the economy.US construction spending tumbled in October at .8%, double the rate of decline that was expected. But today’s release by the National Association of Purchasing Management in Chicago added a little light as their gauge of business activity climbed to 52.9 from 49.7 in October. Readings greater than 50 signal growth.

It is now becoming clear that the sub-prime debacle has much more power than earlier thought to sideline the US economy. Revised government figures showed that the economy grew a whopping 4.9% in the quarter just prior to this one. That’s the strongest showing in four years. We may be looking at the worst quarterly economic performance in the last four years this quarter. The last recession was in 2001. 

Equity markets have rallied over the past couple of days on speculation the Fed will cut rates. But as this day wears on, it looks like investors are taking a more cautionary view that the Fed may be too late or that they cannot do enough to avoid recession. Time will tell, but the trend suggests substantial caution in the near-term.

Have a good weekend.