Gerard Baker: Fed calm amid the storm

By Gerard Baker
FT.com site; Jun 26, 2002

As the world's investors took cover on Wednesday from the latest accounting bombshell to hit Wall Street, Federal Reserve policymakers put on a familiar display of phlegmatic order amid the turmoil.

The US central bank, as expected, prosaically left its main monetary policy instrument, its target for the federal funds rate, unchanged for the fourth straight meeting of its policymaking open market committee (FOMC).

But with US equity markets plunging through the low point they reached in the weeks after September 11, it must have been a troubling thought for policymakers that the combination of Kenneth Lay and Bernie Ebbers had done more damage to Americans' wealth than Osama bin Laden and Mohammed Atta.

Last autumn, the Fed cut interest rates aggressively to shield the economy from terrorist-related blows to confidence. So far, and with not much further room for cuts, it has sat tight as markets have steadily crumbled in the past four months.

Fed officials are concerned about equity weakness - and indeed about the steep slide in the dollar that has accompanied it. But, going into this week's FOMC meeting, policymakers remained cautiously optimistic that recovery would not be derailed.

The biggest source of comfort is that, despite the big declines in equity values so far this year, the real economy continues to show encouraging signs of life. Overall, output growth in the second quarter of the year, which ends this weekend, will be a little more disappointing than looked likely two months ago but should still be in the range of 2.5 per cent at an annual rate. That is well below the inventory-adjustment-driven 5.6 per cent pace of the first quarter but still consistent with steady recovery.

Especially encouraging has been the manufacturing sector, which is several months into a recovery from a two-year slide. On Wednesday, the Commerce Department reported that durable goods orders rose by 0.6 per cent in May, the fifth increase in the past six months. Signs of strength in the capital goods markets are what the Fed has been hoping to see, since they should signal the start of a gradual revival in business investment - the collapse of which was the main factor that drove the economy into recession last year.

And for all the concern in markets about the dollar's decline, Fed economists like to point out that the stimulative effect on exports will at least counterbalance the deflationary impact on US financial assets.

Consumers hold the key. Fed policymakers have looked with awe on American consumers' resilience in the past few years. But they also know that part of Americans' capacity to keep spending has been provided by the Fed itself. In late 1998, when markets swooned after the Russian debt default and Asian financial crisis, and again after the September 11 attacks last year, Alan Greenspan and colleagues moved aggressively to cut short-term interest rates.

This time, with the Fed running out of ammunition, falling stock prices could be more problematic for consumer spending. Consumers remain stretched, with heavy debt burdens and historically low savings rates. And this week the Conference Board, an independent research group, reported that June had seen the steepest fall in consumer confidence since last autumn, as Americans seemed to take fright at the events on Wall Street.

Yet consumers may receive a shot of adrenaline from the same forces that have been sending stocks lower. As equities have declined in the past few months, bond prices have shot higher, sending interest rates lower. As a result, the housing market - where big gains have, for most Americans, more than offset the impact of falling stock prices - remains as strong as ever. Yesterday, the Commerce Department reported that new home sales in May rose by 8.1 per cent from a month earlier. Consumers seem to be in the early stages of another round of mortgage refinancing, which should put hundreds of billions of dollars back into their pockets.

This may represent a belated adjustment in longer-term interest rates to the Fed's aggressive easing of last year. Or it may simply show that the market is once again ahead of the central bank in rebalancing financial conditions in the economy.

The critical factor is that, as long as inflation stays low, the stimulus from lower interest rates need not be reversed any time soon.

That is again the source of cautious Fed optimism. In spite of increases in energy prices this year, consumer prices remain flat - indeed some measures of inflation are showing the lowest rate of price increases in more than 40 years. Though the dollar's decline will push up import prices and some domestic prices, the US is still a relatively closed economy and is not likely to see a generalised and sustained increase in prices as a result of events on currency markets. Against that backdrop the Fed is under little pressure to raise interest rates.

This same low inflation is, Fed officials believe, part of the reason for the weakness in equity markets. Policymakers do not appear to share some of the more alarmist views of inter- national investors that the accounting issues at World- Com and elsewhere mean US corporate reports are fundamentally untrustworthy, although clearly there are many significant problems. And it is hard to attribute the entire decline in US equity prices in the past six months, or even the bulk of it, to the corporate governance issue.

A large part of it may be the result of the weakness of nominal demand in the economy. Inflation is low or even negative, so the relatively small increases in real demand of the past six months are reflected in very small gains in nominal demand - and in corporate sales and profits. Put another way, companies face a situation, unprecedented in the recent past, in which they have virtually no pricing power, even as real demand starts to recover.

Of course, further steep falls in equity prices would complicate the Fed's task, especially if accompanied by a dive in the dollar. But for the moment, a benign inflationary environment and declines in market interest rates are keeping alive hopes at the central bank that a navigable path can be found through the unravelling of 1990s excess.