Federal Reserve Sees New Risks for Economy

As the Bush administration wrestled with what to do about the economy, Federal Reserve policy makers signaled Tuesday that they would act to keep the nation from sliding back into a recession though it was too soon to cut interest rates again.

The Fed’s statement was one of several important economic focal points Tuesday.

At his economic forum in Waco, Texas, President Bush tried to restore investor and voter confidence. But as his guests met, the country’s biggest airline--American--announced a significant restructuring that will lead to the loss of 7,000 jobs.

That move came after US Airways on Sunday sought bankruptcy protection and amid continuing speculation that the parent company of United Airlines might have to do the same. One key analyst voiced his concerns about a bankruptcy filing for UAL Corp., and its stock plunged.

For consumers, there were mixed messages in the economic news Tuesday.

The airlines’ actions led to speculation that fewer flights, and less emphasis on the hub system that many airlines use, could lead to higher air fares and longer waits for travelers. Also on the horizon, analysts predicted: reduced first-class service and fewer opportunities to use frequent-flier miles.

Homeowners, on the other hand, got some good news with expectations that mortgage rates, already at 30-year lows, could conintue to drop, analysts said. That’s because some investors fled the slumping stock market and sought a safe haven in Treasury securities, driving yields on longer-term bonds to levels not seen since the 1970s. Mortgage rates generally track Treasury bond yields.

All this provided a backdrop to the discussions in Waco, where Bush said he and his economic advisors would be getting “a report from what I call the front lines of the American economy.”

The report was generally upbeat: Participants backed Bush’s initiatives. But the president didn’t mention the American Airlines layoffs, and Democrats continued to criticize the forum as a public relations ploy.

In Washington, the Federal Reserve left its benchmark short-term interest rate unchanged at 1.75%, a 40-year low, dashing investor hopes for a quick cut to bolster business and consumer spending. But in its official statement, the Fed indicated that it is now worrying about whether the economy, hit by slow growth and increasing unemployment, will stall.

Chairman Alan Greenspan and his colleagues implied that they are prepared to lower rates if necessary.

“The Fed is effectively saying that the economy is worse than we thought,” said Sung Won Sohn, chief economist at Wells Fargo & Co. in Minneapolis.

The central bank’s tone rattled financial markets, where bonds attracted money at the expense of stocks. The Dow Jones industrial average sank 206.50 points, or 2.4%, to 8,482.39, though trading was relatively subdued.

The economy’s strength in the first quarter, when real gross domestic product surged at a 5% annualized rate, withered in the spring. GDP growth slowed to a 1.1% rate in the second quarter, according to the government’s official estimate reported July 31.

Many employers have been reluctant to hire workers, creating a virtually jobless recovery so far. And layoffs continue to dominate in some industries, such as airlines.

Also, after a promising first quarter, orders for durable goods fell in June; and a key manufacturing index showed that growth in the factory sector slowed sharply in July.

Consumer spending, which accounts for about two-thirds of the economy, has remained a bright spot. But the government’s report Tuesday of July retail sales showed that, apart from spending on cars and fuel, expenditures were flat. An ABC News/Money magazine poll released Tuesday said consumer confidence fell last week to a six-year low.

But the economy is giving off a number of positive signals as well. Worker productivity remains solid, the housing sector continues to sizzle, and corporate profits have begun to recover.

“If you size up all the numbers, the rebound is continuing. Maybe not at the pace we’d like, but it is continuing,” said Mickey Levy, chief economist at Bank of America.

A mixed economy has prompted a cautious response from the Fed. In contrast to its June meeting, when the central bank’s Federal Open Market Committee expressed guarded optimism about the economy’s prospects, the 12-member group this time highlighted conditions that threaten to squash the rebound that began in the fourth quarter of last year.

The Fed said the slowdown in demand for goods and services that began in the spring “has been prolonged in large measure by weakness in financial markets and heightened uncertainty related to problems in corporate reporting and governance”--references to the accounting scandals that helped crush the stock market in June and July.

“The Fed is clearly worried about the economy,” said economist David Jones, president of Denver-based DMJ Advisors, who predicts the central bank will cut its benchmark rate by half a point, to 1.25%, by year’s end. “They are ready to cut rates as an insurance policy to keep the recovery on track,” he said.

In the meantime, the Fed’s decision Tuesday to stand pat leaves its target for the so-called federal funds rate at a four-decade low of 1.75%, where it has been since December. The federal funds rate is the cost of short-term loans among banks. That rate, in turn, is used by banks to set the prime lending rate, to which many business and consumer loan rates are pegged.

The Fed slashed the federal funds rate 11 times last year, from 6.5% in January 2001, marking one of the most aggressive rounds of cutting in the central bank’s history. The moves have been widely credited with softening the blow of last year’s recession by keeping U.S. consumers spending after the technology stock bubble burst and business investment collapsed.

The housing sector may get another boost soon: The average rate on 30-year mortgages fell last week to 6.31%, the lowest since mortgage-finance giant Freddie Mac began tracking rates in the early 1970s. Mortgage rates are tied to yields on long-term Treasury bonds, and those yields are tumbling anew.

The yield on the 10-year Treasury note, the principal benchmark for mortgages, fell Tuesday to 4.09% from 4.21% on Monday, and now is the lowest since the government began regular sales of the securities in the 1970s.

The strong demand for Treasury securities reflects a number of factors, experts said. For one, many investors believe the Fed will indeed cut short-term rates in the fall, leaving room for longer-term yields to decline as well.

Also, a strong fear factor is in the market, analysts said: Concern that the U.S. economy is faltering, and that the recovery in stock prices that began in late July will be cut short, is driving many investors to put their money into Treasury securities as a safe-haven move.

“Clearly the ‘flight to quality’ is an issue” in yields’ latest slide, said Robert Auwaerter, a bond portfolio manager at mutual fund giant Vanguard Group in Valley Forge, Pa.

The Fed, aware that another dive in share prices could further undermine the economic recovery by hurting consumer and business confidence, wanted to send a signal to Wall Street on Tuesday that the central bank is ready to ease credit again in the fall if necessary to forestall recession, analysts said.

“They do think we’re going to come out of this all right,” said Louis Crandall, economist at Wrightson Associates in New York. “But they wanted to show they’re not blithely ignoring all the turmoil around us.”

But with short-term interest rates already the lowest since John Kennedy occupied the White House and with consumers shouldering record amounts of debt, some economists question whether additional rate cuts can do much to juice the recovery.

Although monetary policy has proved effective at propping up the housing sector, Edward Leamer, director of the UCLA Anderson Forecast, said lower interest rates may do nothing to address other concerns weighing on the economy, including sluggish business investment.

“Wall Street needs to see a significant increase in corporate profits ... and business spending,” Leamer said. “But Alan Greenspan can’t wave a magic wand and make that happen.”