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Fed changes stance
December 19, 2000: 4:29 p.m. ET

FOMC abandons fight against inflation; indicates slowing growth is a concern
By Staff Writer M. Corey Goldman
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NEW YORK (CNNfn) - For the first time in two years, Federal Reserve policy makers signaled that recession, rather than inflation, poses the greatest risk to the record U.S. economic expansion, paving the way for a reduction in interest rates as soon as their next meeting, at the end of January.

As expected, the Fed's policy-making arm, the Federal Open Market Committee, left the funds target for overnight loans between banks at 6.5 percent -- the fifth consecutive meeting over seven months that it has held the rate at that level. The discount rate -- the rate at which the Fed's 12 district banks lend directly to member institutions -- remained at 6 percent.

graphicBut FOMC members surprisingly and abruptly switched off the inflation alarm bells, altering their assessment of the risks to the economy as being slanted toward slowing growth or even a recession. By definition, a recession is two consecutive quarters of negative growth.

In their statement, the members acknowledged that rising energy prices, eroding consumer confidence and reports of substantial shortfalls in corporate sales and earnings have slowed the pace of economic activity. "While some inflation risks persist, they are diminished by the more moderate pace of economic activity and by the absence of any indication that longer-term inflation expectations have increased," the FOMC said.

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graphicCNNfn's Lisa Leiter reports from Washington.
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"The Fed opted not to pull the trigger on a rate cut today, but did the next best thing by leapfrogging its policy bias away from inflation to one which sees more risks from economic deterioration," said Andrew Pyle, chief markets strategist with Scotia Capital Markets. They signaled that the risk of the economy slowing down too quickly is a significant concern, he said.

Markets react negatively

U.S. stock markets sold off after the announcement as investors expressed some disappointment that the Fed didn't move even more aggressively by cutting rates immediately. Even so, the sell-off was limited on expectations that the Fed is paying due attention to slowing economic activity, and will act in the near future to prevent the economy from stalling out.

The Fed's concern about the slowing pace of the economy is a marked departure from previous statements, which had focused on the threat of accelerating inflation -- a phenomenon that officials had repeatedly cited as the greatest risk to the record 117-month-long expansion. The Fed began raising rates in June 1999 and pushed up the overnight bank rate by 1.75 percentage points in six steps to combat perceived inflation pressures.

graphicBut with the exception of higher energy prices, faster inflation never materialized. On an annual basis, the core rate of inflation, which strips out volatile food and energy costs, rose at a 2.6 percent rate last month, a shade above the 2 percent pace recorded a year earlier.

An absence of inflation, combined with a wrath of data showing declines in retail sales, manufacturing output, durable goods orders and consumer sentiment, among other things, prompted some to question whether the Fed's last, half-point hike was too much. The economy expanded at a 2.4 percent annual rate in the third quarter, less than half the 5.6 growth pace of the second. And the unemployment rate ticked up a notch for the first time in three months.

"The Fed did not lower the fed funds rate, but their statement indicates a 180 degree about-face in terms of their view of the risks facing the economy," said David Orr, chief economist with Charlotte, N.C.-based First Union Corp. "It looks to me they're ready to do what they have to do when they have to do it. They just aren't exactly sure when they have to do it."

Turning on a dime

Indeed, on a dime, what appeared to be an imminent threat of an overheating economy and accelerating inflation has quickly turned into what some say may be an imminent threat of recession, where consumers and businesses pack away their check books and refuse to spend. The textbook definition of recession is two straight quarters of negative growth.

The last time the Fed cut rates was in 1998, when the Russian debt crisis, the Long Term Capital Management collapse and a subsequent credit crunch crisis threatened to strangle markets and investor confidence. The Fed lowered rates three times in rapid-fire succession to return liquidity to financial markets and restore investor confidence.

  The drag on demand and profits from rising energy costs, as well as eroding consumer confidence, reports of substantial shortfalls in sales and earnings, and stress in some segments of the financial markets suggest that economic growth may be slowing further.  
  From FOMC statement  
Lara Rhame, a senior economist with Brown Brothers Harriman, told CNNfn that the wording of the Fed's three-paragraph, one-page statement all but guarantees a reduction in interest rates at the Fed's Jan. 30-31 policy meeting. (429KB WAV) (429KB AIFF)

One element that has not previously factored into the Fed's musings over the economy has been the struggle American companies have had in keeping their profits in line with Wall Street's standards, prompting earnings warnings in spades from some of the country's more high-profile companies. Higher rates have prompted customers of many firms to ax their capital spending plans, leaving unfilled order sheets in their wake.

Another element is the consumer. Companies such as Gillette Co. (G: Research, Estimates), Microsoft Corp. (MSFT: Research, Estimates), Clorox Co. (CLX: Research, Estimates), Black & Decker Corp. (BDK: Research, Estimates), Polaroid Corp. (PRD: Research, Estimates) and a host of other companies that rely on consumers' penchant to spend have all warned that their profits won't live up to Wall Street's expectations.

The stock market factor

All those factors tie in to the dismal performance of U.S. stock markets this year. Consumer sentiment has been severely crimped by stock market volatility as the so-called wealth effect all but disappeared. The Dow Jones industrial average is down more than 7 percent for the year, while the Nasdaq composite index is down more than 36 percent.

graphicDiane Swonk, chief economist with Banc One, told CNNfn that the Fed's principal focus is U.S. consumers, and that keeping them spending is the key to ensuring the economy doesn't stall. (234KB WAV) (234KB AIFF)

Outgoing President Bill Clinton said Tuesday that he did not think the U.S. economy would sink into a recession, telling reporters during an Oval Office meeting with President-elect George W. Bush that slower economic growth is probably the order of the day going forward. "Well, a recession is two quarters in a row of negative growth. I don't think we're going to have that, but we couldn't keep up 5 percent growth a year, you know, forever," Clinton said, adding that he believed that a large majority of U.S. economists predict U.S. growth of 2.5 percent or better next year.

No matter how much the economy slows, investors are bracing for a rate cut come January. The February fed funds futures contract has an implied yield of 6.16 percent. That's more than a quarter percentage point below the current 6.5 percent overnight bank rate. The April contract has a yield of 5.93 percent -- suggesting a half-point cut by then. Fed officials next meet Jan. 30-31 to discuss the economy and monetary policy. graphic


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