With the U.S. economic recovery losing steam and the outlook clouded by the possibility of war with Iraq, a volatile stock market and corporate accounting scandals, Federal Reserve officials appear likely to cut short-term interest rates before the end of the year, perhaps as soon as at their next policymaking meeting.
The officials' concern, expressed in recent public speeches and private conversations, is not that the economy is headed for another recession -- a "double-dip" after last year's. Rather, some Fed officials worry that the economy has virtually stopped growing over the past two months and will grow only weakly for an extended time, making it vulnerable to a shock such as a protracted war in Iraq that could cause oil prices to go up and U.S. consumers to curtail their spending.
Fed officials are scheduled to meet Nov. 6 -- the day after Election Day -- when they could reduce their 1.75 percent target for overnight interest rates. However, rather than act immediately after the election, some might prefer to wait until their next meeting, on Dec. 10.
At their last meeting, on Sept. 24, a majority of the central bank's top policymaking group, the Federal Open Market Committee, left the target unchanged, but two members dissented in favor of a rate cut.
Most economic data since have indicated weaker rather than stronger growth, including a sharp 5.9 percent drop in new orders for durable goods in September, which the Commerce Department reported yesterday. The two dissenters, Fed Governor Edward M. Gramlich and Robert D. McTeer Jr., president of the Dallas Federal Reserve Bank, therefore probably still favor a rate cut. It also is likely that other members of the Open Market Committee would have preferred to lower rates last month but deferred to Fed Chairman Alan Greenspan's choice not to.
Given that background and the weakness of the data, Greenspan probably would have little difficulty achieving a consensus for lowering the target by either a quarter or a half percentage point. One important factor is that officials see no sign of inflation problems. Another is that while some analysts have questioned whether reducing the already low target further would stimulate growth, Fed officials believe it would help.
The October employment report to be released Friday could affect the decision on interest rates. And should Greenspan decide that a rate cut is still premature, a majority of the committee would go along with him, with some dissenters.
The majority's statement after the last meeting said the committee still believed that economic growth would pick up but that "considerable uncertainty persists about the extent and timing of the expected pickup in production and employment owing in part to the emergence of heightened geopolitical risks." That uncertainty, officials believe, is a key reason that businesses are postponing investment decisions.
There is also considerable concern that the corporate accounting scandals and the legislative and regulatory responses to them are causing business executives to act more conservatively than usual in making commitments to invest and hire. Yet another worry is that growth is weakening in both Germany and Japan, perhaps hurting the market for U.S. exports.
"Looking forward, the economy remains a fragile balancing act between resolute consumers and skeptical businesses," Cathy E. Minehan, president of the Boston Federal Reserve Bank, said in a speech last week. "So far, the consumer's optimism has more than offset business pessimism. But how long can the consumer hold out? The risks here seem firmly on the downside."
In her New England region, Minehan said, the outlook "remains highly uncertain and forward-looking indicators have failed to improve," suggesting that "expansion is unlikely in the next six months."
In a similar vein, the president of the St. Louis Federal Reserve Bank, William Poole, said in a talk Wednesday that the economy is "recovering all too slowly from last year's recession."
The Commerce Department is expected to report Thursday that the economy grew in the July-September period at an annual rate of 3 to 4 percent, after adjustment for inflation. That would mean the U.S. economy grew about 3 percent since September 2001.
That growth has produced only small increases in payroll employment this year. Meanwhile, the number of private-sector jobs remains about 1.2 million lower than it was a year ago.
Many forecasters expect economic activity to increase at no more than a 2 percent annual rate in the final three months of the year, with slow improvement in 2003. With productivity -- the amount of goods and services produced for each hour worked -- rising strongly, the growth predicted in those forecasts could go hand in hand with a rising unemployment rate.
Many Fed officials have assumed that if consumer spending kept rising, businesses -- which cut way back on investments in new plants and equipment during the recession -- would resume spending. Such spending did pick up slightly in the second quarter of this year and probably increased again in the third. However, those gains have not been enough to lift the economy onto a healthy growth path, in the view of many Fed officials.
Economist Janet L. Yellen, a former Fed board member now at the University of California at Berkeley, said she "had expected investment spending to revive and lead to growth that was at least high enough to keep unemployment from growing."
"Now I'm not sure," Yellen said. "With the possibility of war with Iraq looming, my impression is that firms are reluctant to make new investments."
The Fed's latest survey of nationwide economic conditions found that manufacturing activity "decreased or grew more slowly in September and early October" in most of the country. "Tough," "stagnant," or "sluggish" were some of the words factory executives used to describe the business conditions they faced, the survey summary said. In particular, the survey found "a reluctance of manufacturers to undertake capital spending."
Tony Raimondo, president of Behlen Manufacturing Co., a Nebraska-based metal fabrication firm that employs about 1,300 people, is head of a small business committee for the National Association of Manufacturers. Recently Raimondo said that companies such as his remain very cautious about investment decisions.
"We have to have the uncertainties clear up. It is extremely difficult to do any forecasting in this climate," Raimondo said. What is needed is more certainty about whether demand for products will increase and for banks to become more willing to extend credit to smaller firms such as his, he said.
Some analysts have raised two questions about cutting rates. First, since at 1.75 percent the Fed's target is not far from zero, should the Fed lower it any more unless it is absolutely necessary? Second, would a rate cut help spur growth?
Officials believe that if a rate cut is needed, they should not delay it because the target is already so low. They also believe that a rate cut would help the economy, though they are not sure how large the impact would be because the target has never been so low in the decade and a half that it has been used as a policy tool.
Former Fed vice chairman Alan S. Blinder agreed with both views.
"If the problem is really the war with Iraq, which is what really worries me, then a rate cut would help but not be a cure," Blinder said in an interview. The impact from a cut might or might not be smaller than if the current target were higher, he said, but "I don't see any reason to suppose that monetary policy loses its punch at very low interest rates."
Yellen agreed that a rate cut would have an impact. Even if the current target level is providing some stimulus to the economy, as many Fed officials have said, it may be "not stimulative enough," she said.