Signals Point to Another Cut in Rates by the Fed
A sudden decline in short-term interest rates suggests that the Federal Reserve may officially ease credit again soon--for the first time since last July.
The recent dip in short rates, along with a flurry of weak economic reports, is putting pressure on the Fed to acknowledge the economy’s still-fragile recovery--and give it a boost by pumping cheaper money into the system.
“I would be very upset if the Fed doesn’t ease by summer,” says a worried Sung Won Sohn, chief economist at Midwest banking giant Norwest Corp. in Minneapolis. “I think they’d be making a mistake in overestimating economic strength.”
A Fed decision to cut rates again--perhaps as much as half a percentage point--would have far-reaching implications on Wall Street, of course.
People with money in bank and S&L; savings certificates would see their already-meager interest earnings slide further. Savings yields typically fall one-quarter to one-third of a point soon after a half-point Fed cut, says Robert Heady of the newsletter Bank Rate Monitor. That would probably push more savers into stocks and into bonds, pulling long-term interest rates down as well.
But any Fed cut also runs the risk of looking like a blatant political sellout to the Clinton Administration, which has made clear that it expects lower interest rates to ease the pain of proposed income tax hikes.
For that reason in particular, many economists believe that the Fed isn’t yet ready to act. “I think the Fed sits on its hands for now,” says Donald Straszheim, economist at Merrill Lynch & Co. in New York.
Yet the evidence arguing for easier credit--even with short-term rates now at 30-year lows--is piling up:
* The government’s report that March retail sales took their biggest drop in two years raised new fears that consumer spending is waning. Though much of the drop was attributed to bad weather in the East, “I think sales were weaker than the weather alone would suggest,” Straszheim concedes.
Worse, consumer spending could take a bigger hit this month and in May, because many Americans were shocked to find out that they owed Uncle Sam on tax day Thursday--thanks to changes in tax withholding tables a year ago.
* The nation’s money supply--the grease that makes the economy go--has been contracting this year, by some key measures. So-called M2, which is currency in circulation and cash in checking, savings and money market accounts, has fallen at an annual rate of 1.3% so far this year. The Fed’s goal for the year: 2% to 6% growth in M2.
While the money supply figures have been skewed by the dollars leaving short-term accounts for bonds and other higher-yielding investments, Norwest’s Sohn contends that the implication is the same: There’s less cash around to give the economy a short-term boost. “Historically, M2 has absolutely been the best indicator for predicting the economy,” Sohn says.
* Returns on three- and six-month Treasury bills, bellwethers of market expectations on short-term interest rates, seem to be telegraphing an official Fed cut. The discount rate on three-month T-bills, for example, has slumped from 2.98% in mid-March to 2.83% now, lowest since last fall.
“A Fed easing has already been built into T-bill rates,” agrees David Jones, economist at bond dealer Aubrey G. Lanston & Co. in New York.
But like Merrill’s Straszheim, Jones believes that the market is wrong in its assumption about a Fed cut. He notes that Wall Street also was sure of an imminent Fed cut last October--but it never came. Then, as now, many analysts saw the economy weakening and insisted that the Fed needed to act.
Instead, the central bank decided to wait. And in fact, the economy improved dramatically in the fourth quarter with Bill Clinton’s election.
Though Jones concedes that the March economic numbers were dismal, he notes that data this month already suggests a better picture. Auto sales, for example, rose sharply in the first 10 days of the month. And while job creation isn’t robust in this recovery, it’s better than many people believe, Jones insists.
Straszheim says the Fed won’t even consider making a move until it sees full-month figures for employment and retail sales in April.
If those numbers are abysmal, expect another rate cut, he says. Otherwise, the Fed will probably do nothing.
The great unknown in the interest-rate equation, however, is how much political pressure the White House will be able to exert on the Fed. Clinton Administration officials have bent over backward to portray the economy as anemic--a good ploy if you’re trying to push a job-creation bill through a skeptical Senate.
And the Clinton camp would probably like nothing better than to drive more bank savers into long-term bonds.
As individual savers’ money has flooded bond mutual funds in search of yield this year, long-term interest rates have dropped sharply, cutting mortgage rates as well. That’s exactly what the Administration needs to offset the economic drag of its onerous tax hikes.
Could the White House force the Fed to ease, perhaps prematurely?
Most Fed watchers believe the opposite is more likely: That the Fed, eager to guard its independence, could decide to wait longer on the economy, rather than appear to cave in to Clinton.
But then, it’s also worth remembering where Fed chief Alan Greenspan was sitting during Clinton’s State of the Union speech: Right beside Hillary.
Primed for a Cut?
While the Federal Reserve’s last cut in its official discount rate was half a point in July, 1992, a sharp drop in other short-term rates recently suggests that the Fed may soon be forced to cut again.
Mid-June Interest rate 1992 Now Change Fed discount rate 3.50% 3.00% -0.50 pts. 3-month Treas. bill 3.67% 2.83% -0.84 pts. 6-month bank CD yield 3.72% 2.92% -0.80 pts. 1-year bank CD yield 4.06% 3.20% -0.86 pts. 1-year Treas. bill 3.99% 3.07% -0.92 pts.
T-bill rates on a discount basis.
Source: Bank Rate Monitor; Federal Reserve Bank of St. Louis
