Shock Therapy
______________________________________________
SmartMoney.com - The Economy
Wednesday April 18, 7:10 pm Eastern Time
By Roben Farzad
<<IN THE WEEKS since the Fed cut interest rates by half a percentage point on March 20, the bond and equity markets — not to mention most economists and journalists — gradually came to the conclusion that the central bank wouldn't make any more moves before its next meeting on May 15.
They were wrong. On Wednesday morning, the Federal Reserve slashed its benchmark federal-funds rate by one-half point, to 4.5% from 5.0%, and lowered the more symbolic discount rate on Fed loans to member banks by a half point to 4.0%.
After a few milliseconds of shock on Wall Street, stocks took off like a rocket. The Dow Jones Industrial Average finished the day up 399.10 points, or 4%, while the S&P 500 gained 46.63 points, also 4%. The Nasdaq, meanwhile, soared a stunning 156.22 points, or 8%.
The latest move, on top of this year's cumulative point-and-a-half worth of cuts, was applauded as proof the Fed is serious about bringing the slumping economy back to its feet. But this easing — the fourth this year and the second to come between regular meetings of the policy-making Federal Open Market Committee — arrives at a curious time, long after the Street's cries for aggressive Fed action had died down. The question is, why now?
To be sure, recent economic data have been disappointing. Last Thursday's retail-sales figures, which showed a 0.2% decline in March after no change in February, underscored the effects of job losses and declining stock wealth on consumer spending. Core retail sales, which exclude autos, dropped by 0.1%. Economists had expected total retail sales to rise 0.1% and nonauto spending to increase by 0.2%. Moreover, two weeks ago the Labor Department reported that first-time claims for unemployment insurance climbed by 9,000 to a five-year high of 392,000 during the week ended April 7. And the Blue Chip survey of economic forecasters pointed to an increase in the likelihood of a recession. While the January consensus put the chances at 31%, that figure rose to 38% by this month.
Even so, there were more than a few indicators arguing that the economy is at least beginning to turn the corner — indicators so persuasive that Wall Street increasingly began to discount the possibility of an intermeeting rate cut. While retail sales did dip in March, for instance, they still grew by a healthy 4.5% annual rate during the first quarter as a whole (4.7% excluding autos), which indicates a gain of about 3.5% in overall consumer spending, according to Salomon Smith Barney economist Steven Wieting. (The actual level of first-quarter consumer spending will be revealed on April 27, when the Commerce Department reports its preliminary estimate of first-quarter gross domestic product.)
Moreover, the Conference Board's index of consumer confidence rose to 117 in March from an upwardly revised 109.2 in February. Economists had expected the index of household sentiment to decline to 105. Perhaps more important, the forward-looking component of the index, which tracks expectations for the next six months, rose to 83.6 in March from 70.7 in February. On top of that, housing starts are still relatively healthy: Despite a small 1.3% breather in March, starts for the first quarter were 5.3% higher than in the fourth quarter of last year, and multifamily starts rose 10.4%.
Then, there were the recent optimistic comments by regional Fed presidents. Just two weeks ago, Atlanta Fed President Jack Guynn hinted that the economy might already be out of the recessionary woods. ``My sense is that the rate of deterioration has slowed,'' he said, adding that signs increasingly pointed to the economy being ``close to bottom.'' And just last week, the St. Louis Fed's William Poole put the odds that the economy would slip into recession at just 25%. While he conceded that ``a recessionary scenario is not necessarily off the table,'' Poole stood by his prediction that there is a 50% chance of an uptick in the remainder of 2001.
Fed watchers seized on these statements as sure signs that there would be no intermeeting cut. ``For Mr. Greenspan to orchestrate an intermeeting cut,'' wrote Deutsche Bank Chief U.S. Economist Peter Hooper on April 10, ``either the economic data [would] have to be weaker than expected or financial-market conditions [would] have to turn decidedly more bearish. Presently, odds of an intermeeting cut are still south of 50%.''
That sentiment was reflected in the bond markets, where prices — which are typically spurred higher by the prospect of falling interest rates — suddenly began falling, and yields — which move in the opposite direction — started to rise. Short-term yields rose 0.39% between April 6 and April 16, while the yield on the 10-year note gained 0.35% during that same period and the 30-year bond yield approached a five-month high. Similarly, 30-year mortgage rates crept up during the period. (On Wednesday, bond yields didn't move much, even after the surprise rate cut, as the equity markets were the stars of the day.)
Perhaps the fact that no one expected an intermeeting cut is precisely why the Fed decided to act. The Fed is leery of appearing to respond mechanically to any single indicator, so the recent conflicting signals may have given it intellectual cover to act on its fundamental belief that the economy is still at risk of further slowing. As the FOMC said in its policy statement on Wednesday: ``The risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.'' Those risks, the committee said, include slowing capital spending, the impact of slumping stock prices on consumer behavior and signs that the economic downturn is spreading around the world: ``Capital investment has continued to soften and the persistent erosion in current and expected profitability, in combination with rising uncertainty about the business outlook, seems poised to dampen capital spending going forward. This potential restraint, together with the possible effects of earlier reductions in equity wealth on consumption and the risk of slower growth abroad, threatens to keep the pace of economic activity unacceptably weak.''
And while Fed Chairman Alan Greenspan has acknowledged the importance of the stock market's health to that of the overall economy, he has also been wary of doing anything that smacks of propping up equities. To do so, he is said to fear, would be to suggest to investors that the Fed stands ready to bail them out — a signal that might prompt them to take greater risks than they otherwise might. And so as stocks tumbled in February, Greenspan resisted deafening calls from the market for an intermeeting rate cut. This time around, Greenspan & Co. chose to act soon after the Nasdaq had staged a six-day rally of nearly 20%, and on a day when the Dow was already up 188 points — hardly conditions that had Wall Street crying for immediate Fed action.
``The Fed is clearly sending the message that it is targeting the economy and not the stock market,'' says Dan Ascani, president and research director at Global Market Strategists. ``It only accentuates that point by making that move today.''
Now, pundits are busy contemplating what the surprise cut means for the stock market for the rest of 2001. After all, nearly 50% of American families own equities in one form or another, and, including today's surge, all three major indexes are still down significantly from their 2000 peaks. The Nasdaq Composite has been the hardest hit, shedding a painful 59% since March of last year.
The results of the last surprise rate cut (back on Jan. 3) don't offer much consolation. The stock market also rallied sharply that day — when the Fed made a similar half-point cut — with the Dow rising 300 points, the Nasdaq popping 325 and the S&P jumping 64 on unprecendented volume. Alas, as we know from the painful first-quarter performance of the stock market, that euphoria turned out to be a one-day wonder.
But many things are different this time. For starters, stock valuations are considerably lower than they were in early January, thanks to the Nasdaq's 16% slump year-to-date, not to mention the Dow's 2% drop and the S&P 500's 6% decline. At the same time, estimates of corporate earnings were still unrealistically high at the beginning of the year: the consensus estimate for S&P 500 earnings per share was still at $61.88 at the time of the last intermeeting cut. Today, after a tidal wave of warnings from companies across the economic landscape, Thomson Financial/First Call's consensus estimate stands at $54.25. Put it all together, and it's clear in retrospect (the only place where such things are clear) that stocks still had a long way to fall on Jan. 3. And it also seems at least possible that we're at or near a bottom this time around.
Merrill Lynch's Bruce Steinberg insists investors have good reason to be bullish. Using history to predict the future, he has tracked the correlation of the decline in the fed-funds rate with the market's performance since the 1950s. When the Fed has cut either two percentage points or reduced the fed-funds rate by 30% from its peak (a milestone reached Wednesday), the market gained an average of 25% the following year.
Along with many other economists and market watchers, Steinberg believes Greenspan will ease again in May, cutting another half point. But as Wednesday's action showed, predicting Greenspan's actions isn't as easy as it used to be.>> |
