As economy steadies, is rate cut necessary?

Fed's Tough Decision

In recent weeks, the stutter-step American economy - and its volatile markets - has made firm strides toward stability.

Since the Federal Reserve unexpectedly cut interest rates one month ago, the Dow Jones Industrial Average is up almost 1,000 points and the capital markets, although still selective, are showing some signs of confidence. At the same time, the economy has remained healthy - even if it is growing at a slower pace - and consumers continue to shop with abandon.

Even overseas markets have calmed. The International Monetary Fund (IMF) has mounted a rescue effort for Brazil, a major US trading partner. And the dismal Russian economy is no longer on the front pages.

Reasons for a cut

Yet despite the economic good news, the general feeling on Wall Street is that when the Fed meets today it could very well lower interest rates by another 0.25 percent to keep the markets from backtracking.

"Any goodwill can be undone rather quickly," says Kevin Flannigan, a money-market economist at Morgan Stanley Dean Witter in New York.

Clearly, it's a difficult decision for the Fed, which must weigh signs of prosperity with the ongoing fragility of global markets. "It's a very close call," says John Burgess, a managing director at Bankers Trust Co. in New York.

A dose of skepticism

Wall Street investors acknowledge the signs of stabilization in the US economy, but many are wary of putting too much faith in the recent uptick. In fact, the Federal Reserve announced yesterday that US industrial production fell for a second straight month in October. It was the slowest operating rate in more than six years.

Mr. Flannigan also points out that lenders are still being cautious. For example, Coca-Cola, a high-grade corporate borrower, usually can borrow money at 80 basis points (0.8 percent) over the interest rate paid by US Treasury bills. Coke is now paying 1 percent over Treasuries. "While investors are putting their toe back in the water, it's not with any great conviction," he says.

This type of move in the markets, although subtle, is now watched carefully by Fed Chairman Alan Greenspan. He realizes that widening spreads may indicate a shift in investor psychology - an important ingredient in a healthy economy.

Still, there are some signs of life in the markets. Last week, an Internet company, theglobe.com, went public. The stock rose from $9 per share to $63.50 on Friday. At the same time, some large companies were successful in the debt markets. "Deals are getting done," says Mr. Burgess.

In fact, with the markets returning to some normalcy, some economists argue the Fed should stand pat for a while. They say the US economy is not in any danger of a recession. Instead, they believe that too much easing may ignite inflationary fires.

"The case for cutting rates further is not very strong at this point," says Charles Plosser, dean of the William Simon School of Business in Rochester, N.Y.

For example, last week, the government reported retail sales rose by 1 percent in October. Although a significant portion of the increase was attributed to strong automobile sales, economists believe the numbers indicate consumer spending remains buoyant. Merrill Lynch economist Cheryl Katz estimates fourth-quarter spending will rise by 4 percent.

"This is not sustainable and we look for consumer spending to moderate next year," she says. She thinks the strong consumer spending may be a factor in keeping the Fed on the sidelines.

Mr. Plosser is concerned that the Fed is too loose with the money supply, which is growing at a 10 to 12 percent annual rate. If that growth continues, he maintains, a new round of inflation won't be far away. "The Fed is walking a very tight rope," he says.

Last week, however, the government reported the Producer Price Index - a key inflation indicator - rose only 0.2 percent, hardly a sign of problems.

Still, this was higher than Wall Street had anticipated. Ms. Katz says this rise was prompted by special factors - such as sky high vegetable prices - that should reverse themselves.

Greenspan, however, is less concerned with traditional economic indicators. For example, he distrusts the money supply numbers mentioned by Plosser.

Benefits of technological change

Instead, in his speeches, he says the US economy is now enjoying the benefits of technological change. During the past decade, businesses have kept abreast of these changes, he says, helping them improve productivity. As a result, companies can better control inventories and production runs.

For these reasons, Greenspan says traditional measures of the economy, such as the unemployment rate, have a different meaning. So Greenspan's decision today is more likely to be flexible, reflecting the dynamics of the marketplace.

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