Obsessing Over a Recession

A drop in jobs shortens the odds the Fed will cut rates.


Can Ben Bernanke save the economy? For much of Wall Street, and now Main Street, that's really about the only question left. Last week's surprisingly nasty jobs report—the economy lost 4,000 jobs in August rather than gaining 100,000 as expected—decisively ended the debate over whether the Federal Reserve would cut interest rates at its next policy meeting on September 18. Persistent job growth had been the one notable bright spot in the economy lately, but with the subprime mortgage crisis and credit crunch apparently starting to metastasize, "the Fed has little choice but to cut the federal funds target rates after this report," says Jason Trennert, chief investment strategist at Strategas Research.

OK, fine. So the Bernanke Bunch tries to work its monetary magic later this month and cuts the federal funds rate—stuck at 5.25 percent since June of 2006 —by a quarter percentage point. Who knows, maybe it even cuts the rate by half a point and then does a couple of more quarter-point cuts at the October and December meetings. What then? A look at Fed history shows that there is really nothing magical at all about Fed rate cuts, at least not right away. Alan Greenspan's Fed cut interest rates twice in January 2001, yet the economy shrank in both the first and third quarters of that year. "It really takes six to nine months for rate cuts to have any meaningful effect," says William Ford, former president of the Atlanta Fed bank.

Ford is still a bull on the economy, but many bears agree that whatever economic damage the mortgage crisis has done is already baked into the cake. Economist David Rosenberg of Merrill Lynch sees the economy weakening despite the Fed. "We're looking at 1½ percent GDP growth for next year," he says, "The economy is going to be weak enough to send the unemployment rate higher by at least a percentage point. My expectation is that the housing downturn is going to morph into the consumer sector in the next year." Indeed, some of Merrill's fancy computer models put the chances of recession at 70 percent.

There was certainly plenty to be gloomy about even before the jobs number. The National Association of Realtors says its index of pending home sales fell to its lowest level since September 2001. And new Commerce Department data show residential construction activity plunged by 1.4 percent in July. That's the biggest amount in six months. And remember, these are all numbers that predate the credit crunch of August. "The eye of the storm, unfortunately, may lie just ahead, not behind," concludes economist Patrick Newport of Global Insight, an economic consulting firm.

And this isn't just about an inability to get a "ninja"—no income, no job, no asset verification—loan. The credit tightening has moved beyond the mortgage market as fixed-income investors have fled to the safest investment possible—short-term U.S. treasury bills. The amount outstanding of commercial paper—short-term corporate borrowings—has plunged by nearly $300 billion over the past month.

Crisis of confidence. Still, a Fed easing might have some extra oomph if what's really wrong with the economy is as much a shortage of confidence as a shortage of liquidity. "There is definitely a crisis of confidence because of the uncertainty as to where the subprime mortgages have landed," says Edward Yardeni of Oak Associates. "I think [the Fed] will do 50 basis points. That may be enough to stabilize the situation, and I think by next year we should be looking at real GDP growth at about 3 percent."

And there are still a few who think Bernanke should stand pat. As they see it, the economy—which grew at 4 percent in the second quarter, 4.7 percent excluding housing—is still plenty powerful to blast its way forward. The Fed's own Beige Book survey of economic conditions in August found "limited" impact on the economy from the turmoil in financial markets. "I think there's a little bit of financial market self-absorption going on," says Robert Stein, senior economist at First Trust Advisors. "They think that everything that affects Wall Street negatively is going to affect Main Street negatively, and that's just not the case. There are a lot of crybabies in Connecticut and Manhattan." Maybe, but the crying just turned into a full-fledged scream.