Awaiting revival, Fed still cutting

The last time interest rates went this low, it was the Age of Camelot, Beatlemania had not hit American shores, and the moon was a romantic object unacquainted with an American flag or a lunar module.

On Tuesday, it will be memory lane all over again if, as expected, the Federal Reserve cuts interest rates another quarter percentage point, or back to the same level as when Ike was president and every teenager wanted a Chevy with tailfins.

The move would bring the Fed's short-term rate to 1.75 percent, down from 6.5 percent at the beginning of this year. The move would mark the 11th rate reduction this year - part of the steepest round of cutting in US history. Many economists expect another cut at the end of January in a bid to spur new borrowing, spending, and investment.

The most aggressive Fed action ever comes at a delicate time for the US economy. Some fresh signs of activity were counterbalanced Friday by a sharp rise in unemployment.

The jobless rate rose to 5.7 percent, the highest level since 1995. Over the past two months, the nation has lost 799,000 jobs, the sharpest pace since 1980.

Economists now expect the unemployment rate - which tends to keep rising even as a recession is ending - to peak out next year at between 6.5 percent and 7 percent.

"[The numbers are a] rude wake-up call for those who think the recession is over," says Bruce Steinberg, chief economist at Merrill Lynch. Since last March the nation has lost some 1.2 million jobs, and the latest job losses mean the economy continues to remain soft.

But a few economists see signs of improvement.

For example, automakers have been steadily reducing their inventories, which are now at levels that will prompt companies to get the assembly lines rolling again and recall workers. "Our calculations show that even in the current quarter, there would be positive growth without the inventory drawdowns," says Sung Won Sohn, chief economist at Wells Fargo Banks in Minneapolis.

Mr. Sohn, just back from a business trip to California, says Silicon Valley companies are finally starting to get new orders as businesses begin upgrading their computers again.

"They seem more optimistic than they have been in a long time," Sohn says.

In fact, he argues the Fed should not cut interest rates, since that would send a message to the economy and investors that the bank is not confident about the recovery. "It may send the wrong message," he says.

Some economists, however, argue the Fed's message is different: It wants to not just bring down the cost of borrowing, but also reduce the incentive to hold cash. If interest rates get low enough, companies will decide they can make more money investing in their businesses than by stockpiling cash. And investors will decide the returns in the stock market are better than those from certificates of deposit.

"You are likely to have less idle cash," says Mark Vitner, a senior economist with First Union Bank in Charlotte, N.C.

So far, the bond and stock markets are cooperating. The Dow Jones Industrial Average has climbed back to the 10000 level as investors look for bargains and anticipate better economic times next year.

Bond prices have fallen - increasing yields - as investors have begun to anticipate the Fed will start to raise rates sometime next year as part of its normal braking process. "The Fed can't control expectations," says Robert Brusca of Ecobest, an economic consulting firm in New York.

This change in the bond market is reflected in mortgage rates.

Prospective home buyers are finding that interest rates have climbed back to about 7 percent, up from 6-3/8 percent only a few weeks ago.

By way of comparison, when short-term interest rates were this low during the Kennedy era, mortgages were under 6 percent.

"I'm not sure the Fed wanted long-term rates to go up," says Stuart Hoffman, chief economist at PNC Financial Group in Pittsburgh.

The Fed's actions will benefit short-term borrowers, such as buyers of automobiles and corporations that issue commercial paper. Some credit-card interest rates might also fall as well. "It's more top quality: If you are not top quality, your rates won't come down," Mr. Hoffman says.

In recent weeks, Fed governors have continued to warn that there are still risks for the economy. Consumer confidence, although improving, remains weak. Rising unemployment in the months ahead will not help.

Many economists predict that the economy's transition from recession back to growth will take place by next spring. That would mean the recession, which began in March, would have lasted about a year.

"The Fed is trying to cushion and put a bottom to the economy and contribute to the recovery," Hoffman says.