Fed acts, but a dip still looms

The US economy is now slowing so quickly some economists believe it is close to a negative growth rate – and perhaps the forerunner to a recession.

This sudden downshift in America's economic fortunes is one reason the Federal Reserve has dropped interest rates at its last three meetings – including a quarter point drop Tuesday. However, a growing chorus of economists believe the rate reduction may be a case of too little, too late.

"The odds of a recession are now above 50 percent," says Mark Zandi, chief economist at Moody's Economy.com. "We are right on the edge of a recession in part because of the Fed's reluctance to reduce interest rates more aggressively."

In its statement on Tuesday, the Fed acknowledged the economy "is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending." However, Mr.

Zandi says the central bankers should have gone further. "They are misjudging the risks," he says. "The fragility of the financial system is the key risk."

Yesterday, the Federal Reserve signaled it was acting more aggressively to address problems in the financial sector. It announced it was coordinating with the European Central Bank, the Bank of Canada, and the Swiss Central Bank to provide additional liquidity for commercial banks. The Fed's actions helped to rally the stock market, which recovered most of its losses from the prior day when investors were disappointed with the Fed's quarter-point interest rate cut.

"This is positive news," says Scott Brown, chief economist for Raymond James & Associates in St. Petersburg, Fla. "It helps solve some liquidity problems, not just in the US but globally."

The new action will allow commercial banks to bid for funds that are placed in a special "auction" facility. This means banks having trouble raising money in the financial markets may obtain funds. The borrowers from the new facility will be anonymous, a key feature for the banks since it will help them avoid the stigma of borrowing.

The financial markets have not yet recovered from their meltdown this past August when banks started to detail their loan losses on sub-prime mortgages. Since then, banks have reported multi-billion losses and become more reluctant to lend money despite interest rate reductions by the Fed. There are some reports that the Fed may act within days to try to ease credit conditions.

"The Fed is late and they know it," says Gregory Miller, chief economist at SunTrust Banks in Atlanta.

On Tuesday, after the Fed's rate drop, the Dow Jones Industrial Average plunged 294.26 points, or 2.1 percent. The financial markets had been looking for a half a percentage point drop.

"Just when you thought that the Fed 'got it' following the dovish and credit-focused speeches by Messrs Bernanke, Kohn, and Mishkin two weeks ago, the tepid move today and mixed tone in the press statement suggest otherwise," wrote David Rosenberg, chief economist at Merrill Lynch & Co. to his clients.

Mr. Brown says the Fed's latest actions with the European central bankers is not a cure-all. "It won't solve the housing crisis or prevent the economy from slowing down," he says.

However, the Fed is also looking at an economy that in the third quarter showed no signs of strain. The Gross Domestic Product (GDP) rose by a rapid 4.9 percent, bolstered by exports.

"More often than not the economy accelerates just before it goes over the cliff and then the downturn is over before we even know we're in it," says Mr. Miller.

One major worry for economists is the reaction of CEOs to the economic clouds. The National Federation of Independent Business (NFIB) reported Tuesday a sharp drop in business confidence.

"The survey hit a 14-year low, which is what makes this significant," says Robert Brusca of FAO Economics in New York.

He says the drop in the NFIB index correlates with consumer spending. "This is where most of the jobs are – in small business – so when small business is doing well people have more money to spend."

The NFIB survey also found business becoming increasingly reluctant to spend money on capital projects. Such spending is critical for the economy to grow new jobs, says Miller. "That is the first part that generates demand for new jobs," he explains. "If business expects the economy to slow, they are less likely to spend money from their own pockets to expand."

There are already some economic statistics that show business is getting nervous. Inventory to sales ratios are now at a historic low. Mr. Rosenberg worries that business could pare back inventories even more as the economy slows. He estimates slower inventory accumulation will take 1.1 percent off the growth rate of the GDP in the current quarter. This would imply the current quarter is now negative, he says.

Zandi cautions that because the economy was so strong in the third quarter, it's easier for the economy to show negative growth in the current quarter. "It overstates the weakness," he warns.