Silence of the Fed Would Be Warning of Slowdown Ahead
By Pierre Belec
NEW YORK (Reuters) - The countdown to the first anniversary of the Federal Reserve's latest pre-emptive strikes on the economy is under way. Will the central bankers call a truce in their inflation-fighting war? You betcha.
The economic reports are pouring in and the scorecards show signs the Fed winning after battering the economy with six rate increases since June 1999.
In a case of bad news being good, stocks got a lift this week from speculation that the Fed might be on the final leg of its interest-rate-raising campaign, now that there are signs of an economic slowing.
The betting is that the central bank will take pity on the economy, which is starting to register hot instead of scorching after its dousing with a half-dozen rate increases over the last year. The Fed's policy-setters meet June 27 and 28, the one-year anniversary of the start of their restrictive money policy on June 1999.
The fallout from escalating lending rates includes a rise in the jobless rate to 4.1 percent in May from a 30-year low of 3.9 percent in April, a decline in housing starts, a drop in retail sales for the second month in a row and a slippage in manufacturing activity.
Experts say the Fed may back off and leave interest rates alone in June, and perhaps even at its Aug. 22 meeting for fear that an overly aggressive money policy could wreck the economy.
Big changes are taking place in the economy as the impact of the 175-basis-point surge in interest rates fully works its way through the economy, says Kent Engelke, capital market strategist, for Anderson, Strudwick Inc., noting the long-time lag before tighter money does the job of capping growth.
``It is generally accepted that it takes between six to nine months before the effects of higher interest rates are felt,'' he said.
``The economy is now only responding to the first 50 to 75 basis points of tightenings. There are still another 100 to 125 basis points to contend with,'' Engelke said.
``Feeling the impact of Fed tightenings is similar to running a marathon,'' he said. ``The first 21 to 22 miles are not bad but it is the last three miles that are killers. We are only in the first 12 to 14 miles of the run. The toughest part is still in the distant future.''
The Fed first raised short-term interest rates on June 30, 1999, moving by 25 basis points and then tacking on two 25-basis-point increases on Aug. 24 and Nov. 16. This year, it raised by 25 basis points on Feb. 2 and again on March 21 and followed up with a bigger 50-basis-point hike on May 16.
The Fed's goal: Make it more expensive for people and businesses to borrow so that demand for stuff will taper off and the economy will slow down, thereby preventing a flare-up in inflation.
Strong consumer spending has fueled the economic boom, particularly in the housing market. That sector got an added lift from low mortgage rates and rising wages in the absence of inflation.
Often, too strong an interest-rate remedy has created a deep downside risk for the economy and even recession.
But the consensus for now is that a recession is not in the cards since the economy is still in great shape. Fed Chairman Alan Greenspan also doesn't want to be blamed for delivering a knockout punch that would send the economy to its knees.
More likely, analysts say, the economy might experience a hard landing, which is defined as growth of only 1 or 2 percent for three or four consecutive quarters and a jump in the jobless rate.
There are other reasons to believe the Fed will think twice before pulling the interest-rate trigger again.
Banks are starting to get slammed because more people are defaulting on their loans and some banks have been lax in adding to their safety nets, known as loan loss reserves. The risk of loan defaults has risen in proportion to the steady increase in interest rates by the Fed.
Wachovia Corp. (WB.N), a big southeastern bank holding company, has warned that a $200 million increase in loan loss reserves in the second quarter, due to a rise in bad loans, will hurt its earnings. And there's speculation that other banks are in the same boat as Wachovia, a bank with a reputation for being one of the most prudent lenders.
``If a well-run bank such as Wachovia is experiencing a deterioration in the credit quality of its assets, imagine what is happening to some of the less well-run banks,'' said Paul Kasriel, chief U.S. economist for The Northern Trust Co. in Chicago.
Also reporting loan-related problems were UnionBanCal Corp. (UB.N) and Pacific Century Financial Corp. (BOH.N) parent of Hawaii's largest commercial bank, Bank of Hawaii.
Standard & Poor's, the rating agency, said as the credit cycle shows more evidence of souring, it expects that problem loans will continue to climb through the remainder of the year, not only at Wachovia, but throughout the industry.
The nation's banks are toughening their lending standards. But the restrictions also may have been the result of people just naturally coming up to their credit limits after years of go-for-broke spending.
Some Wall Street analysts cautioned that it may be too early to think that rate-king Greenspan has ``left the building.''
The interest-rate script may change by the time the central bank holds another meeting on Aug. 22. By late summer, the Fed will have pieced together enough information about the economy, which should clear up the confusion about whether last month's reports of a downturn are flukes.
``If the economy is slowing, as it appears to be, then the next big question is, 'To what pace?''' said Allen Sinai, chief global economist for Primark Decision Economics. ``A slowdown from the prior boom could be 4 percent economic growth or 3 percent, or as little as 2 percent.''
The Fed wants to reduce the economy's speed limit to what it views as an acceptable 3.5 to 4 percent annual growth rate, after GDP grew at a brisk 6 percent in the last three quarters.
``In addition, there is yet another question -- whether the hesitation and pause in economic activity in the current quarter is just that, a quarter, perhaps two, period of weakness in response to several quarters of huge booms,'' Sinai said. ''Economic data tend to ebb and flow, on a quarterly basis without necessarily portending a major shift to another growth path.''
Are the negative economic reports too good to be true?
The Conference Board says the economy may have peaked but don't be fooled by one or two months' worth of bad numbers. The slowdown is only temporary, it said, and more interest-rate increases are waiting in the wings.
The economic research group is forecasting that the first quarter of 2000 will be the fastest-growing period of the year, with the Gross Domestic Product climbing by 5 percent, year on year. And by the end of 2000, GDP growth will slow to 4.4 percent. But even such a growth rate would exceed the Fed's acceptable annual growth.
``At these growth rates, the Federal Reserve will still be disposed to raise short-term interest rates for the foreseeable
future,'' said Gail Fosler, chief economist for the Conference Board.
``In this environment, business will encounter both top-line and bottom-line pressure, with the negative impact on profitability showing up in the second half of the year,'' she said.
The bottom-line is that these are very uncertain times.
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