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A Hawk Changes His Feathers

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.