Fed likely to cut rates Tuesday, but next move unclear

Handicapping the Fed

May 14, 2001: 12:09 p.m. ET

The Fed will likely cut interest rates Tuesday, but what happens next?
By Staff Writer Mark Gongloff

NEW YORK (CNNfn) - There's little doubt the Federal Reserve will cut interest rates for the fifth time this year when it meets on Tuesday.

Nor is there much disagreement that the Fed will cut its target for the federal funds rate, a bank overnight lending rate, by half a percentage point to 4 percent in an ongoing effort to pump life into the sluggish U.S. economy.

What is in doubt is what the Fed will do for an encore.

Watching consumer spending
The likelihood of a half-percentage-point cut grew when the government reported early this month that unemployment hit a 2-1/2 year high in April as employers cut more jobs than anytime since the end of the last recession.

When people fear for their jobs they spend less, and consumer spending fuels two-thirds of the U.S. economy and is closely watched by the Fed.

"The employment data showed a lot of weakness," said David Blitzer, chief investment strategist at Standard & Poor's. "Before that, I was on the fence about whether the Fed would cut 25 (basis) points or 50, but I got off in a hurry when I saw that," he said, referring to a quarter-point or half-point cut in rates. There are 100 basis points in one percentage point.

Soon after the unemployment data were released, CNNfn.com polled 16 economists, all of whom said Fed economy policy makers would cut at least half a percentage point at their meeting Tuesday.

In fact, so many investors expect a half-point cut that anything less might hurt consumer confidence as much as no cut at all.

"If they don't deliver, we could see a sharp selloff in markets and a drop in consumer confidence," said Sung Won Sohn, chief economist at Wells Fargo & Co.

Neither Blitzer nor Sohn were swayed by Friday's reports of stronger-than-expected retail sales and a jump in the University of Michigan's survey of consumer sentiment.

"The point is that mounting layoffs and weak consumer confidence will keep consumer spending fairly weak," Sohn said.

'Worrisome' signs of inflation
But the Fed could still find reasons to hesitate. A cut this week wouldn't be felt in the economy until late 2001 or early 2002, by which time many observers think the economy will already be recovering.

By then, taxpayers may also be enjoying the benefits of a tax cut, which could be passed into law by the end of May.

"In the meantime, we're ballooning money supply very rapidly," Sohn said. "That could be dry powder for inflation later on." Sohn said he has seen "worrisome" signs of inflation recently, including a drop in productivity and a rise in the cost of labor.



	The stock market is the canary in the coal mine, and right now it's gasping for air.



	Sung Won Sohn Chief economist Wells Fargo & Co.

"It's quite possible the Fed will have to turn around and raise rates," Sohn said, just as it did in 1994 to avoid inflation after a long series of cuts at the end of the last recession.

The federal funds rate is already at its lowest since May 1994, when the Fed was trying to bring rates back up after several recession-fighting cuts in 1990-1992.

Still, Sohn said, "Right now, the greater danger is the economy sliding into recession, and Greenspan's job is to protect the economy."

Monday's report by the Fed showing industrial output fell by 0.3 percent in April, more than expected, reinforced the view that the Fed will cut by half a percentage point Tuesday.

"We continue to see difficulties for the nation's factories," Kevin Flanagan, a fixed-income strategist at Morgan Stanley, told Reuters. "This is a figure that continues to argue for the Fed to (cut a half-percentage point Tuesday)," he said.

When will the Fed start raising again?
What a difference a year makes. At its meeting in May 2000, the Fed raised rates by half a percent to a whopping 6.5 percent, the highest level in nearly a decade, as it tried to brake runaway economic growth and avoid inflation.

The rate hikes contributed to a drop in corporate spending on new technology, which coincided with the explosion of energy costs and the bursting of the technology stock bubble. This led to a decline in consumer confidence and spending, which was also hampered by massive layoffs across a broad range of industries.

The result has been an economic slowdown that the Fed has been desperately trying to halt since the beginning of 2001. Some economists think its work may soon be done.

Carl Weinberg, chief economist for High Frequency Economics Ltd., is one of a handful of economists who thinks the Fed will cut just a quarter-point Tuesday due to inflation fears. He also thinks the Fed could start raising rates again as early as the first quarter of next year.

"The real risk is if the economy starts to recover before year-end, we won't just pick up where we left off, but with a backlog of wage and other pressures on prices," he said.

[Click here for CNNfn's economic calendar]
Other economists are less concerned with the threat of inflation.

"The Fed's not worried about inflation, nor should they be," said Maureen Allyn, chief economist with Zurich Scudder Investments.

The bond market also seems to think the Fed will ignore inflation risks and cut rates aggressively. The implied yield on the June Fed Funds Futures contract is 4.05 percent, meaning the bond market thinks there's about a 90 percent chance the Fed will cut rates by a half-percentage point.

Anthony Crescenzi, bond market strategist with Miller Tabak & Co., told CNNfn's Before Hours program he agreed that rate cutting may end up feeding inflation, but he thinks the Fed has little choice but cut rates further now. (416K WAV) or (416K AIF)

'Canary in the coal mine'
Most economists see recent signs of stock-market stabilization as evidence the economy could begin its recovery in about six months.

"I don't think the market will get lower than it was in March or the beginning of April," said S&P's Blitzer. "It's sending favorable signals to the economy."

And most economists expect only a small gain in the markets when the Fed cuts next week. "If anything," said Wells Fargo's Sohn, "it will prevent the market from falling off the chair."

But that doesn't make it any less important, according to Sohn. "The stock market is the canary in the coal mine, and right now it's gasping for air," he said. "Chairman Greenspan is the one who can give it oxygen."