As spending ebbs, Fed set to act

The Federal Reserve wants to send a message to both Wall Street and Main Street: We don't want to see the economy slide into a recession next year.

On Wednesday, that message is likely to be punctuated by a second consecutive drop in interest rates – this time a quarter-point reduction.

The potential interest-rate cut would mark a shift toward a more forward-looking central bank. Although the Commerce Department is expected to report Wednesday that the US economy grew by a 3 percent annual rate in the quarter that ended last month, economic growth for the current quarter is expected to slow to less than 2 percent. In addition, economists don't anticipate that the economy will get much of a boost from holiday sales, which are projected to grow a modest 4 percent from last year.

Economists thus consider a rate cut by the Fed to be like an insurance policy that could help prevent a potential economic slowdown next year.

"If I were there, in the Fed's boardroom, I would be voting for a further reduction," says Lyle Gramley, an economist and former Fed governor. "The risk to the economy is for further weakening."

One major change taking place: tightening financial conditions, says Mr. Gramley, now a senior economic adviser at the Stanford Washington Research Group. Because of losses in the mortgage market, banks have tightened their lending standards in almost all categories.

In polls, the Gallup Organization has found that 1 in 6 people knows someone who has been turned down for credit, says Dennis Jacobe, Gallup's chief economist in Washington. "We expect that to increase: It takes a while for people to realize standards are tougher," he says. "There is still quite a ways to go on the unfolding impact of the financial crunch."

This may be a reason why consumer surveys show confidence declining. In the past three months, the consumer sentiment survey by the University of Michigan is down 11 points. Economist David Rosenberg of Merrill Lynch & Co. writes that such drops have typically happened around events such as hurricane Katrina or the start of the Iraq war.

With consumer sentiment souring, Mr. Rosenberg estimates that consumer spending in this quarter will grow by only 2 percent, a level that would imply a very slow economy. He says consumer surveys now show 2 out of 3 respondents expect a recession "as the likely scenario in the coming year."

If concerns about the economy spread from Main Street to the corporate boardroom, then the economy could worsen in the months ahead, says Richard DeKaser, chief economist at National City Corp. in Cleveland. "If the housing market and the financial market lead CEOs to believe the probability of a downturn has increased, they will hire and invest more conservatively or not at all," says Mr. DeKaser. "Fear of the downside can be self-realizing."

Some of the fears were manifested in a confidence survey of small-business owners released Monday by National City. It found that business confidence dropped 1.4 percent to a new low in October, in large part because of credit-market tightening. Small-business owners also said they were adversely affected by the declining value of the dollar, which is raising the prices of energy and some commodities.

On Monday, the price of oil continued to rise, registering more than $92 a barrel in the morning. Energy analysts blame rising tensions in the Middle East and reports that Mexico was shutting down some oil production.

Economists will get a better read on the business mood this Friday, when the Labor Department reports on hiring in October. So far, initial unemployment claims have remained at a level that does not indicate any major layoffs are taking place. "In a recession, those numbers really rocket upwards," says Gramley. "It appears hiring rates have slowed, but not many people are being laid off."

It would not be unusual for the labor market to trail the economy, Mr. Jacobe says. In 2002 and 2003 when the economy came out of the last recession, employment growth was slow. Economists termed it the "jobless recovery."

"Now when we ask people if it's a good time to find a quality job, in the last month or two we've seen the first downticks," says Jacobe.

On Wednesday, the Fed will also have to consider the impact on Wall Street if it does not lower interest rates. The stock and bond markets fully anticipate a rate cut. "The Fed usually likes to keep expectations in line," says DeKaser.