Rate Cut Will Reveal Extent of Fed Worries

Federal Reserve policymakers are all but certain to cut short-term interest rates this week for a sixth time this year, and are likely to point to the usual suspect: a corporate sector whose weakness stands in sharp contrast to the consumer sector’s resilience.

Just how worried the Fed still is about U.S. companies’ shrinking earnings will be evident in the size of this week’s cut--and in the statement the central bank issues with its decision, expected late Wednesday morning Pacific time.

By late last week a growing number of analysts were forecasting a half-point cut in the Fed’s key rate, though that camp still was in the minority.

A Reuters poll of 25 primary Treasury bond dealers found that as of Friday, 10 expected a half-point drop in the Fed’s target level for the federal funds rate, the overnight loan rate among banks. That would reduce the rate to 3.5% from the current 4%.

The 15 other dealers expected a quarter-point cut, to 3.75%.

As of June 15 a poll of the same bond dealers found six forecasting a half-point cut and 19 betting on a quarter point.

Whatever the size of the decline, it would mark the first time the Fed’s key rate has been below 4% since early 1994. But after five half-point rate cuts already this year, whether this week’s Fed move would set the stage for a rebound in the foundering corporate sector isn’t clear, many analysts say.

In any case, those on Wall Street arguing for another half-point cut say the Fed can’t afford to sit still with many companies continuing to face soft sales and crumbling earnings.

From business’ viewpoint, “the economy simply shows too few signs of turning around,” said Martin Mauro, manager of financial economics at Merrill Lynch & Co. in New York. “Manufacturing activity is getting worse, and the risk is rising that service-producing industries get dragged along.”

At the same time, analysts note that U.S. consumers overall seem relatively unfazed by the economy’s deceleration this year--despite the surge in layoffs nationwide.

“In the midst of [corporate] doom and gloom, retail sales, while not spectacular, are doing fine,” said Sung Won Sohn, economist at Wells Fargo & Co. in Minneapolis. “Wages continue to rise faster than inflation. Home values, the most important source of household wealth, continue to move higher.”

On the face of it, relative strength in the consumer sector argues for Fed Chairman Alan Greenspan and his peers to indicate in their official statement Wednesday that they might be done, or nearly done, easing credit.

But many analysts believe the Fed will leave the door open for additional rate cuts.

Though consumer spending accounts for the bulk of economic activity, the Fed, to some analysts’ surprise, has made a point of stressing its concern about the corporate sector’s woes.

Indeed, in the statement after the central bank’s last rate cut, in mid-May, policymakers specifically cited the slowdown in corporate capital spending and the general weakness in companies’ earnings.

“Investment in capital equipment . . . has continued to decline,” the Fed said in justifying May’s half-point rate cut. “The erosion in current and prospective profitability, in combination with considerable uncertainty about the business outlook, seems likely to hold down capital spending going forward.”

Edward Yardeni, investment strategist at Deutsche Banc Alex. Brown in New York, said the Fed could use similar language in this week’s statement because “not much has changed since the last two easing moves” of April 18 and May 15.

In fact, since the Fed’s last rate cut, the corporate sector has faced a fresh barrage of bad news:

* The government reported that the factory capacity utilization rate fell from 78.2% in April to 77.4% in May, the lowest since 1983.

* The number of companies warning that second-quarter earnings will be below already lowered expectations has zoomed, and the affected sectors include more than manufacturing and technology.

Last Friday, for example, drug giant Merck saw its shares slump 9% after the firm said the strong dollar and weaker-than-expected sales of its arthritis drug Vioxx will cause it to miss analysts’ quarterly earnings estimate.

* Prices of key commodities have continued to slide amid falling demand. Though a decline in oil and natural gas prices may be welcomed by many companies, lower commodity prices in general signal that economic weakness is spreading worldwide, analysts say.

Last Thursday an index of industrial metals prices tracked by Moody’s Investors Service dropped to its lowest level since early August 1999. Moody’s calls the index a “reliable barometer of global economic activity.”

Yet there also has been some good news on the manufacturing front recently. The June index of manufacturing activity in the Philadelphia Fed bank’s region, reported last week, showed that the rate of decline of activity had slowed--and that 63% of firms are expecting an improvement in business in the next six months.

Some economists believe the Fed has cut interest rates enough and now just needs to let those cuts work their way into the economy. But that camp is a distinct minority.

With the stock market still down year to date, layoffs and bankruptcies rising and few signs of a turnaround in spending on technology equipment, yields on short-term Treasury securities continue to signal that the Fed isn’t done cutting.

At the same time, a renewed decline in long-term Treasury bond yields since early June suggests that Wall Street, for now, isn’t concerned that the Fed’s aggressive credit easing will produce higher inflation down the road.

As long as inflation concerns remain subdued, the Fed has more room to slash short-term rates, analysts note.

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Betting on Lower Rates

The yield on the six-month Treasury bill has fallen well below the Federal Reserve’s key short-term rate, which is now 4%. That indicates investors expect at least one more rate cut from the Fed, and perhaps more.

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Six-month T-bill yield, weekly closes

Friday: 3.41%

Source: Bloomberg News