Morning Report for Thursday, June 7, 2001

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A Hawk Changes His Feathers

By Paul Shread (mailto:pshread@internet.com)

June 7, 2001 - The most significant statement to come from the Federal
Reserve in recent months came not from Chairman Alan Greenspan, but from
Fed Governor Laurence Meyer, who yesterday expressed doubt that a
second-half economic recovery will occur.

"While a recovery along the lines of the consensus forecast is reasonable,
I see some downside risks to that outlook," Meyer said in a New York
speech. "There are no signs yet that the economy is strengthening relative
to its first-quarter performance, and growth is likely to remain sluggish
into the third quarter."

An assessment that blunt from a Fed official is rare. Coming from Meyer,
it amounts to a sea-change in the Fed's view of the economy, and investors
should take notice.

Meyer's influence on the Fed trails only that of Greenspan's. He is the
unacknowledged leader of the Fed's hawkish wing, and is believed to be one
of the primary reasons that the Fed took so long to begin cutting interest
rates.

What is doubly surprising about yesterday's speech is that Meyer actually
softened his tone on inflation. With productivity suffering its worst drop
in eight years, you would think an inflation hawk like Meyer would be
alarmed.

"But because the slowdown started from a relatively low level of
inflation, the desirability of a significant decrease in inflation rates
is not as great as it has been in the past," he said. In other words,
there is no push from the Fed's hawks to shift bias or end the
rate-cutting cycle anytime soon. For one of the Fed's most hawkish members
to be more worried about the economy than inflation after 250 basis points
in rate cuts speaks volumes about the risks to the economy.

Meyer even admitted that his inflation-fighting bias may have been
overdone. "Some, including myself, may have over-weighted our concerns
over resource utilization rates during the high-growth period but
underestimated the dangers from growing imbalances in other areas. ...
[T]he absence of the emergence of inflationary pressures, and therefore of
a rise in real interest rates to contain them, may have contributed to an
environment in which asset bubbles and real investment excesses could
develop."

And that last sentence is why Fed rate cuts may not do much to help this
time. Overinvestment takes time to work off. If the problem is that
businesses and individuals took on too much debt and overbuilt or
overspent on the assumption that the economy and the stock market would
grow indefinitely, then easy credit in the form of lower interest rates
isn't going to help much.

The recovery depends on business inventories being reduced and investment
in productivity-enhancing technologies and new economy opportunities
rebounding, Meyer said. But he also said the memory of last year could
restrain investment for some time.

All of this may not have been preventable, but we would argue that the Fed
should have seen it coming sooner. Here's a quote from the August 4
edition of our Market Close:

"Recession indicator: short-term treasury bond yields rose above 10-year
bond yields last week and have stayed there since. Over the last 40 years,
this phenomenon occurring for two consecutive months has presaged a
recession within six months 86% of the time. Short-term yields are now
threatening to rise above 5-year yields; if they do, the yield curve
inversion will be complete. There are positive factors behind the
inversion, such as the government's buyback of long-term bonds due to the
federal budget surplus, but it is nonetheless worth keeping an eye on."

The indicator gave a firm signal in October, about the same time that GE
CEO Jack Welch reportedly told Alan Greenspan that he was seeing worrisome
signs in the economy. The Fed didn't begin cutting rates until almost
three months later.
We felt compelled to mention the "positive" aspects of the yield curve
inversion last August only because the consensus since the inversion began
in January 2000 was that it was a good thing. Those same economists are
now predicting a second-half recovery for the economy. We won't have to
wait long to find out if they're right, but it's significant that the
leader of the Fed's hawkish faction has his doubts.



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