Wall St. gyrations may leave Fed unmoved

With economic signals mixed, central bank will meet to set interest rates.

By , Staff writer of The Christian Science Monitor

The US now has an economy with a split personality: Some of it is strong, and some of it is weak.

On the positive side, business is showing remarkable productivity growth. Consumers are taking advantage of low interest rates to refinance mortgages, and they're using the money to buy new cars or take vacations. The federal government is adding money to the whole mix through election-year spending and tax cuts.

But on the negative side, manufacturing is wavering again, and job growth has stalled. Surprisingly, the housing market – robust all year – seems to have taken a breather. And the stock markets, after recovering some in August, have gone back into a swoon.

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Economists believe that this mix of strength and weakness probably means the Federal Reserve, which meets tomorrow, will not do anything to interest rates for the ninth month in a row. "There are some indications it might have to lower rates at some point, but not while there is so much uncertainty about the economy," says Lyle Gramley, senior economic adviser at Schwab Capital Markets and a former member of the Fed's Board of Governors.

Some of that uncertainty has to do with how strong the economy actually is. Last week, economists were surprised to see the nation's July trade balance narrow to $34.6 billion, down from $36.8 billion in June. This means that big exporters are starting to get some orders. Moreover, some economists expect that continued consumer spending will translate into the gross domestic product growing by anywhere from a 3.5 percent to a 5 percent annual rate during the third quarter.

"This is acceptable growth," says Stan Shipley, a senior economist at Merrill Lynch & Co.

Employment concerns

Despite the economic growth, the nation hasn't seen a subsequent improvement in new job creation – in large part because of growth in productivity. In fact, the unemployment reports for September and October, which the Fed will have studied by the time it meets again in November, could be persuasive. "I think even with a strong GDP number, they will move to ease," says Mr. Shipley.

In some respects, the bond market has already done some of the work for the Fed. As investors have fled the stock market, they have moved into safe Treasury bills. All the saber rattling over Iraq has prompted foreign investors to do the same. As a result, the yield on the two-year Treasury note has dropped to 1.94 percent, the lowest level since John F. Kennedy was president.

"The market is anticipating a Fed move," says William Sullivan, a money-market economist at Morgan Stanley. "In fact, the market is effectively easing for the Fed."

The drop in bond yields is resulting in mortgage rates that continue to fall. As of last Friday, some banks were offering 30-year fixed-rate mortgages at below 6 percent, the lowest rate since the mid-1960s.

With mortgage rates so low, economists were surprised last week when new home-building dropped 2.2 percent in August, the third straight month of declining activity. Single-family housing fell by 4.4 percent, albeit from a high level.

Dave Seiders, chief economist of the National Association of Home Builders in Washington, blames the weather in the Midwest, where housing starts fell 20 percent. "They had unusually wet conditions in August," he explains. "But there may have also been some effect on builder behavior by the stock-market debacle in July."

But Mr. Seiders sees signs that the industry will bounce back. "In September, there seems to be a better tone."

Breaking the market fall

Investors would certainly like to see a better tone in the stock market. It's a subject that is likely to be discussed by the Fed tomorrow. Since its last meeting on Aug. 13, the Dow Jones Industrial Average has dropped nearly 1,000 points.

Part of the problem is corporate-earnings difficulties. Last week, a whole host of companies, from EDS to J.P. Morgan Chase, said they would not meet their targets. "Expectations were probably too high for earnings growth. There are a lot of write-offs out there," says Shipley.

However, some of the dynamics might be shifting. Economists believe productivity is growing at a 6 to 7 percent annual pace. This should eventually translate into better earnings once orders pick up.

And last week, there was at least one sign that business may be starting to improve. In a survey of its region's business activity, the Philadelphia Federal Reserve Bank found there had been a modest uptick between mid-August and mid-September after a sharp drop this summer.

Economists expect to see some improvement in the August leading indicators index, which is due out today. It is expected to still be a negative number, but not as negative as July.

In addition, there will be a key September consumer-confidence number issued tomorrow. Economists expect that to show modest improvement.

But next Friday, the government will report on the unemployment situation. This is not expected to be as positive – yet one more sign of the economy's split personality.

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