Fed may cut rates again despite strong economic data

The Federal Reserve cut interest rates last week. Despite the relatively strong economic data reported last week, developments in financial markets could yet move the Federal Reserve into cutting rates again in the near future.

Last week's data saw two positive surprises on the US economy.

One was on third quarter real gross domestic product, which, according to the Commerce Department's advance report, grew 3.9 percent. This was the fastest rate of growth since the first quarter of 2006.

The other was on employment, which, according to the Labor Department's non-farm payroll report, increased by 166,000 in October. This was the biggest increase since May.

However, other indicators show that the economy remains in a fragile state.

The Institute for Supply Management's manufacturing PMI fell to 50.9 in October from 52.0 in September, indicating that manufacturing has slowed and is now barely growing.

Even the employment data gave contradictory signals. Although the establishment survey showed strong growth in employment in October, the household survey showed that employment fell by 250,000 in that month. And the initial number from the establishment survey is notoriously unreliable; the August number, originally showing a loss of 4,000 job, now shows a gain of 93,000 jobs.

Despite the conflicting data, Tim Duy opined in his latest commentary on the Fed at Economist's View that the October employment report and the third quarter GDP report showed that the US economy has remained "resilient" to the housing downturn. He thinks that the economy as a whole is "likely growing at somewhere around a 2.75% rate".

Last week's data also showed that inflation in the US was relatively low in the third quarter. The personal consumption expenditures price index excluding food and energy, the Federal Reserve's preferred inflation indicator, rose 0.2 percent in September. In fact, lower inflation helped to push up real GDP growth in the third quarter as the rate of increase of the GDP deflator fell to just 0.8 percent.

Nevertheless, inflation remained at the top end of the Federal Reserve's comfort zone. On a year-on-year basis, the personal consumption expenditures price index less food and energy rose 1.8 percent in September while the overall index rose 2.4 percent.

Indeed, in his commentary, Duy sounded a note of caution on inflation. "I detect something of an upward trend in the past four months, on the order of 50bp," he wrote. "Personally, I wouldn’t break out the champagne on the inflation story just yet."

So it looks like the Federal Reserve is faced with slow growth even as inflation remains barely acceptable to it. No wonder it said in its statement following its meeting last week that "the upside risks to inflation roughly balance the downside risks to growth".

Nevertheless, Duy concluded that the threat of a credit crunch could push the Federal Reserve into making another rate cut in December.

And that is likely to prove the case, what with Citigroup chief executive Charles Prince yesterday being ousted from his position, following in the footsteps of Merrill Lynch's former head Stan O'Neal. The ouster came as Citigroup reported yesterday that it would take an additional $8 billion to $11 billion write-down related to sub-prime mortgages on top of a $6.5 billion write-down last quarter. O'Neal's ouster a few days before had come several days after Merrill Lynch had announced an $8.4 billion write-down for such assets; many analysts think there are yet more write-downs to come for the bank.

As losses become increasingly recognised by banks, expect the credit crunch to tighten. That could lead to fears that the effects of the credit market turmoil on the real economy are only just beginning.