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Fed Lowers Funds Rate, But Conveys December Rate Cut Is Not Certain

Fed Lowers Funds Rate, But Conveys December Rate Cut Is Not Certain

The Federal Open Market Committee lowered the federal funds rate and discount rate 25 basis points to 4.50% and 5.00%, respectively. The policy statement stated explicitly that "upside risks to inflation roughly balance the downside risks to growth." Therefore, a neutral Fed is open to the possibility of having to do nothing, cut the federal funds rate, or raise the federal funds rate. In other words, economic reports between now and the December 11 FOMC meeting will guide the course of monetary policy. Inflation remains on the radar screen given the weakness of the dollar and increases in energy and other commodity prices. President Hoenig of the Federal Reserve Bank of Kansas was the lone dissenter in today??™s vote. He would have preferred an unchanged federal funds rate at 4.75%.

Of the six Federal Reserve Banks requesting a lower discount rate today, the Federal Reserve Banks of New York, San Francisco, and St. Louis were among the seven banks in the list calling for a lower discount rate cut on September 18 also.

A lower federal funds rate in December is remains uncertain. In the event of weakening economic conditions and/or deteriorating financial market conditions, a lower federal funds rate is nearly certain. In addition to the FOMC stating that is now maintains a neutral stance, the language suggests that the Fed is willing to wait and watch.

Q3 GDP Stronger-Than-Expected, Is a Repeat Performance Likely in Q4?

Real gross domestic product of the U.S. economy grew at an annual rate of 3.9% in the third quarter after a 3.8% increase in the second quarter. Strong contributions from consumer spending (+3.0% vs. 1.4% in Q3), exports (+16.2% in Q3 vs. +7.5% in Q2), government spending (+3.7% after a +4.1% in Q2), and total business spending (+7.9% vs. 11.0% in Q2) and inventories ($15.7 billion vs. $5.8 billion in Q2). Offsetting a part of this strength was the sharp 20.1% annualized drop in residential investment expenditures after an 11.8% drop in the second quarter.

The big question is if the performance will be repeated in the fourth quarter. Here are the reasons it is unlikely in the fourth quarter. First, the strength in consumer spending was entirely concentrated in July, with retail sales excluding building materials, autos and gasoline showing noticeable softness in August and September. The weekly chain store sales number for October send a message of a weak performance. Projections of soft employment growth and the absence of mortgage equity withdrawals, additional cash flow to support consumer spending, point to tepid growth in consumer spending in the near term. Second, the jump in inventories was to a large extent from auto inventories, probably a preparation in anticipation of a strike because robust purchases of autos are not expected given the forecast of the soft growth and the recent drop in purchases.

Third, business outlays (structures and equipment spending) grew at an annual rate of 7.9% in the third quarter vs. an 11.1% increase in the second quarter. A further deceleration is likely based on weakness in profits stemming partly from the financial crisis. Profits of the non-financial sector have declined for two straight quarters.

Fourth, outlays related to the war may lift federal government spending but state and local government outlays, which are larger than federal government outlays, are very likely to take a hit because of a reduction in tax revenues, particularly from property taxes. Fifth, exports should be the component of strength going forward, but demand from several trading partners may be constrained from the tighter monetary policy conditions in place in these countries, particularly China and Europe. The bottom line is that the headline GDP in the fourth quarter should be close to 1-1/2%.

Lower energy prices in the third quarter held back the advance of the overall GDP inflation index to a 0.8% annualized gain vs. a 2.6% increase in the second quarter. Core inflation, measured by the core personal consumption expenditure price index, excluding food and energy rose at an annual rate of 1.8% in the third quarter, a small acceleration from the 1.4% gain of the second quarter. Real disposable income advanced at an annual rate of 4.4% in the third quarter following a 0.6% increase in the prior quarter.

Employment Costs Remain Contained

The Employment Cost Index (ECI) moved up 0.8% in the third quarter, following a 0.9% increase in the second quarter. On a year-to-year basis, the 3.3% increase in the ECI was unchanged compared with the second quarter. Wages and salaries increased 0.8%, matching the increase seen in the second quarter. Benefit costs were up 0.8% in the third quarter, after growing at a faster clip of 1.3% in the second quarter.

Hourly earnings, from the employment report, increased 3.98% on a year-to-year basis in the third quarter vs. a 3.90% gain in the second quarter. The year-to-year change in the private sector ECI held steady at 3.1%. The main message is that employment costs do not present an inflationary threat.