Fed caution leaves idea of rate cut in waiting

SHORT-TERM INTEREST

BY JOHN M. BERRY ~ THE WASHINGTON POST

WASHINGTON - Federal Reserve policy makers acknowledged Tuesday that economic growth slowed this spring but they made no change in short-term interest rates, while leaving the door open for a rate cut if growth stays weak.

The Federal Open Market Committee, the central bank's top policy-making group, blamed the slowdown in growth largely on falling stock prices "and heightened uncertainty related to problems in corporate reporting and governance." The market committee's target for overnight rates remains at a 40-year low of 1.75 percent, a level that the officials said is stimulating the economy, which coupled with strong growth in productivity, "should be sufficient to foster an improving business climate over time." However, with financial markets still highly volatile and the lengthy string of corporate accounting and other scandals not necessarily at an end, the market committee members concluded that the risks facing the economy "are weighted mainly toward conditions that may generate economic weakness." At their last several meetings, the committee had said the risk of economic weakness was balanced with the risk that inflation might rise.

Meeting Sept. 24

This shift in the so-called bias in the committee's thinking doesn't necessarily mean that the 1.75 percent target will be lowered at the next Fed market committee meeting on Sept. 24. What happens then will depend primarily on how the economy performs between now and then. There have been numerous occasions in the past when the risk of greater economic weakness was regarded as higher but no rate cut followed.

Some Wall Street analysts were disappointed that the language of the market committee statement suggested that the officials don't expect to reduce rates and that the economy will gather momentum on its own.

"From my view point, the tilt toward weakness was a hollow one," said economist Robert DiClemente of Salomon Smith Barney in New York. "I am not sure what to make of the language because of the background of optimism. I am not satisfied that the current level of rates will be sufficient." "They are inviting us to believe that they are going to ride this out, that their policy is already supportive of expansion," DiClemente continued. "But the cost of cutting here is not very high compared to maintaining the status quo" with financial markets still so uneasy.

Apparently many investors were disappointed that the Fed left rates unchanged. The Dow Jones industrial average closed down 206.50 points, or 2.4 percent, at 8,482.39 and the NASDAQ composite index ended Tuesday off 37.56 points, or 2.9 percent, at 1,269.28.

The stock market rally last week was fueled in large part by rumors that the Fed was planning to cut rates Tuesday, even though only a few weeks before Fed Chairman Alan Greenspan had told Congress that central bank officials remained optimistic about the economic outlook.

'Prudent' decision

Stuart Hoffman, chief economist for PNC Financial Services Group, described the Fed decision as "prudent" because, like the market committee, he believes the economy is doing better now than it did in the spring quarter when it grew at only 1.1 percent annual rate following a strong 5 percent annual growth rate in the first three months of the year.

"It's not exactly a spurt in the economy, but some of the weakness we have seen will not continue, and there will likely be a winding down in the corporate scandals," Hoffman said.

He predicts that the economy will grow at about a 2.5 percent annual rate in the July-September period, led by consumer spending.

Hoffman pointed to the Commerce Department report Tuesday that retail sales rose 1.2 percent last month, with figures for May and June also revised upward, as an indication growth is picking up again. Spending at automobile dealers increased 4.2 percent last month while sales other than at dealers rose a much more modest 0.2 percent.

If the economy performs as Hoffman predicts, he said "the Fed will retain its easing bias in September but will not necessarily need to act to lower their target for the federal funds rate," the interest rate financial institutions charge each other on overnight loans. Economist L. Douglas Lee of Economics from Washington, a financial advisory service, has an even stronger forecast than Hoffman.

When the market committee meets in late September, most will agree the economy has grown at a 3 percent to 4 percent annual rate in the third quarter, Lee told his clients this week. "The fed funds rate will remain unchanged" at the next market committee meeting, he added.

However, DiClemente is concerned about "the abruptness in the turn in the data," such as the unexpected drop last month in the Institute of Supply Management's index of manufacturing activity. The very weak 6,000 increase in payroll employment last month is also a concern, he said.

According to the market committee statement, one reason it did not lower rates was that officials don't think there's any shortage of money in the economy or in financial markets. Financial markets have continued to function smoothly in recent months even though stock prices fell sharply, and there's no shortage of liquidity, analysts said.