The Other Shoe Just Dropped

Mr. Bernanke said he was waiting for timely data to inform the Fed about the strength of the economy. He got some today. The U.S.economy unexpectedly lost jobs in August for the first time in four years according to the Labor Department.USEmployers cut 4,000 workers from payrolls in August, compared with a revised gain of 68,000 in July that was smaller than previously reported. Economists were looking for payrolls to rise by 100,000 jobs. The unemployment rate held at 4.6% as almost 600,000 people left the workforce. 

The Fed just got all the evidence they should need that the USeconomy is slowing fast enough to warrant an immediate cut in the Fed Funds Rate. The question today is not if they will cut, but when they will cut; before or during their meeting on September 18th

Another important indicator comes from the office supply industry. Office Depot and Staples missed rather badly on their recent sales data. Staples reported a 2% drop in same-store sales, down from 4% positive comps last year. As pointed out in a blog on ‘the fly on the wall’ website, “the office supply sector has proven a good measure of economic activity for most of this decade, forecasting the 2002 economic recovery and now, apparently an economic slowdown.” 

Business has been a force against a slowing economy on the strength of its exports to a strong global economy. Experts’ concern that the consumer’s retreat might send the economy into recession was offset by the strength on the business side. But today’s jobs report indicates that businesses beyond the home construction industry may be pulling in their horns. 

Harvard University economist Martin Feldstein, who heads the group that datesU.S.contractions, said Aug. 31 there is a “significant risk” of a recession. “Downturns in housing construction have almost always been followed by a downturn in the economy, by a recession,” Feldstein said in an interview from Jackson Hole according to Bloomberg. “My judgment is there is enough of a risk that the Federal Reserve should be responding to that risk” by cutting interest rates.

Traders boosted their bets that the Fed will lower its 5.25% benchmark lending rate at its September meeting. Fed funds futures showed a 70% chance of a 0.5 percentage point rate cut, compared with a 42% chance yesterday. But according to Bloomberg, four regional Federal Reserve Bank presidents yesterday declined to endorse a cut in the benchmark rate this month as policy makers gauged the impact of credit market losses. We suspect they are simply trying to maintain some maneuvering room. 

One key risk the Fed faces is a slide in the price of the dollar. If they drop rates too fast or too far and foreign investors loose confidence in the dollar’s staying power, they may balk at financing our trade debt. The dollar has been on a steady decline since November of 2005 while the Fed has held rates steady. 

The balancing act becomes more difficult if other major economies’ interest rates remain high or rise. Higher rates boost their economies. Today, European Central Bank policy makers signaled their intention to raise interest rates further to contain inflation once financial-market turbulence has abated. The ECB is “in a process of adjusting interest rates” and “this process hasn’t ended yet,” council member Axel Weber said at a conference inFrankfurt. The ECB, which shelved a planned increase yesterday to leave its benchmark rate at 4%, has a “determination to act in the future whenever it is necessary,” President Jean-Claude Trichet said at the same event. 

With all their talk, however, they are actually holding rates steady while they assess the effects of the credit contagion on global growth. The Bank of England yesterday left its benchmark lending rate at 5.75% and the Indonesian central bank kept its key rate at 8.25%. The Australian and Canadian central banks also opted this week to keep borrowing costs unchanged. The Bank of Japan last month stepped back from plans to raise interest rates. 

We believe that Mr. Bernanke will have to act soon to reverse what appears to be a growing perception on the minds of many economic and business leaders that the economy is going into recession unless credit conditions improve very soon. Banks can’t be forced to lend, but they don’t make money until they do. Reduced rates help lenders and borrowers alike. There is also marginal help as almost a third of adjustable rate mortgages jump to market rates in the next 12 months. A half percentage point reduction might be the difference in whether a family can avoid foreclosure or not.

Model portfolios have done remarkably well through the turbulence of July and August. One of the remarkable things to note has been how similarly markets and asset classes moved during the days of panic. In the late days of July and mid-August when stocks were declining so rapidly, it didn’t seem to matter what country or what sector you chose; they were all down about the same. Even closed-end municipal bond portfolios were mixed into the fray. When high quality long-term investments are indiscriminately marked down in a panic, astute and patient investors stand to reap better-than-average returns.