Investors Question The Fed's Outlook
New Figures Point To Sharper Slump

By Nell Henderson
Washington Post Staff Writer
Saturday, December 2, 2006

Many investors aren't buying the Federal Reserve's forecast for a mild economic slowdown, worrying that a series of recently released figures might signal the onset of a sharper, more prolonged slump.

Stock prices fell yesterday and the dollar extended its recent decline after reports showing that construction spending fell in October at the steepest rate in five years, while the nation's factories produced less in November -- the first monthly drop in manufacturing activity in more than three years.

Those reports followed others last week showing the holiday shopping season got off to a tepid start and that new orders for big-ticket durable goods like airplanes and automobiles fell sharply in October.

The data prompted many analysts to challenge Fed Chairman Ben S. Bernanke's upbeat assessment Tuesday that most of the economy outside of the housing market "appears to be expanding at a solid rate," and his forecast for moderate economic growth through next year.

Investors also boosted their bets yesterday that the Fed, wary of the possibility of a recession, will cut interest rates early next year. They apparently gave little credence to Bernanke's warning that the Fed is more likely to raise rates to tamp down inflation than to lower borrowing costs anytime soon.

Financial markets "are paying more attention to the latest data, which largely contradict what Bernanke was saying," Paul Ashworth, senior economist at Capital Economics, wrote in an analysis for clients yesterday. "It is getting harder for the Fed to argue that the housing slump is not affecting the wider economy. It clearly is."

Some analysts were even harsher. Bernanke is "in denial" about the depth of the economy's slowdown, Ian Shepherdson, chief U.S. economist for High Frequency Economics, told clients on Thursday. Yesterday, he expressed hope the lousy data would push the Fed to consider cutting interest rates by March, if not before.

"The sooner the Fed is shaken out of its complacency about growth, the better," Shepherdson said. "The Fed hiked too far, and has already left it too late to avert a deeper slowdown than was needed."

Some optimists remained unshaken, sharing the Fed's view that consumer spending, which accounts for two-thirds of economic activity, will hold up fine because of low unemployment, rising wages and lower fuel prices.

"I think the markets are way overreacting," said Richard A. Yamarone, director of economic research at Argus Research Corp. "The economy is still moving, but maybe just not at a speed we've been accustomed to in recent years."

Yamarone pointed to the nation's low 4.4 percent unemployment rate in October, saying, "this economy is fully employed. Everybody who wants a job has a job, and that's what determines spending."

A Commerce Department report this week showed greater economic momentum in the summer than previously thought, with the nation's total output of goods and services rising at a moderate 2.2 percent annual rate from July through September.

But pessimists dwelt yesterday on more recent, and grimmer, numbers. Construction spending fell 1 percent in October, for a second consecutive monthly drop, the Census Bureau said. The 1.9 percent drop in homebuilding was the seventh consecutive monthly decline and was widely expected. More troubling was the lack of growth in non-residential construction, which was flat in October and September after more than a year of growth.

"Strength in non-residential construction was supposed to offset the recession in housing. Now that assumption is in question," said Nariman Behravesh, chief economist at Global Insight.

Many economists had also expected factories to continue cranking out enough goods to more than make up for falling production of lumber, nails, roof tiles and other residential building materials. But the Institute for Supply Management said yesterday that its index of total manufacturing activity fell to 49.5 last month from 51.2. A number at 50 or above signifies expansion. It was the first time since April 2003 the index had dropped below 50.

Oil prices also rose this week, with light sweet crude closing at $63.55 a barrel yesterday on the New York Mercantile Exchange.

Stock prices slid yesterday, leaving all the major indexes down for the day. The Dow Jones industrial average lost 27.80 points, or 0.2 percent, to close at 12,194.13.

To some observers, the recent softness appeared uncomfortably reminiscent of the economy's sudden sputtering in late 2000, which gave way to a recession the next year. As late as their meeting in November 2000, Fed policymakers believed the technology sector's sharp downturn would not seriously weaken the broader economy, which still had a very low unemployment rate, 3.9 percent. They remained more worried about inflation and indicated they were more likely to raise than reduce interest rates.

Seven weeks later, on Jan. 3, 2001, the Fed cut its benchmark overnight interest rate to 6 percent from 6.5 percent, expressing concern about the economy's strength. The recession began in March and lasted through November.

The experience in late 2000 demonstrated how quickly the economic outlook can turn, said Laurence H. Meyer, who was a Fed board member then.

Meyer, now vice chairman of Macroeconomic Advisers, said his firm was lowering its forecasts for economic growth this year and next but doesn't foresee the current slowdown snowballing into a recession.

His optimism partly reflects another lesson he draws from the 2000 episode: Fed policy "can equally change quickly."

Bernanke's latest comments do not mean the Fed won't cut interest rates quickly if the economy deteriorates, Meyer said. "Obviously, the beauty of monetary policy is you can turn on a dime."