ECONOMIC ANALYSIS: Succession of Rate Cuts In the Offing for '96, Many

The Federal Reserve let six months pass between interest rate cuts this year. That won't happen next year, according to several economists.

Indeed, bankers should brace for a string of rate cuts from the central bank to offset a softening economy and diminishing inflation.

After Tuesday's reduction - the first since last July - the Fed will cut again in January, do the same in the spring and then push the federal funds rate below 5% as early as next summer, according to NationsBank's Mickey D. Levy.

"The Fed needs to lower the funds rate to 5% just to achieve a neutral monetary policy," said Mr. Levy, chief financial economist at NationsBanc Capital Markets Inc., a subsidiary of the Charlotte, N.C.-based giant.

As he sees it, next year's biggest economic risk "is that the Fed overstays its restrictive stance and generates a slump."

Continuing its cautious approach, the central bank this week lowered its target for the funds rate, the overnight rate on interbank loans, to 5.5% from 5.75%. But it did not cut the discount rate, which remains at 5.25%

Philip Braverman, chief economist at DKB Securities Corp., New York, a unit of Japan's Dai-Ichi Kangyo Bank, expects "another hundred-basis-points reduction in the funds rate from here."

But he noted that "a 4.5% funds rate would amount to removing only half the (credit) tightening that the Fed put in place." From early 1994 to early 1995, the Fed doubled the rate to 6% from 3%.

"It will be a cautious and partial reversal of what I view as a inappropriately tight monetary policy, given the disinflationary trend we are experiencing," he said.

Mr. Braverman expects the inflation, as measured by the consumer price index, to drop to the 2% level next year. And, he noted, that index has been found to overstate inflation.

Two other better measures last year showed inflation already under 2% this year. The consumer expenditure deflator is up 1.9% while the gross domestic product deflator is up just 1.4%.

"The CPI will follow them down next year," he said. But probably not in the first quarter.

"Typically, some companies will try to raise prices early in the year, and then find that demand will not support it," he said. "Then we will see reversals or rebates."

After peaking at 3.2% last May, the annual rate of the consumer price index slowed this fall to around 2.5%.

Neither Mr. Levy nor Mr. Braverman is predicting a recession next year, but as Mr. Levy puts it: "a grinding down in real economic growth seems likely."

In fact, the pattern is already clear, according to the NationsBank economist.

"Final sales will be very weak in the 1995 fourth quarter, the slowest of the year, and businesses are continuing to trim production in order to reduce inventory building.

The economy will probably grow at a 1.5% annual rate in the fourth quarter, on a chain-weighted basis, he said, and growth "will stay below 2% through mid-1996."

Mr. Braverman put the probability of recession next year at 40% right now, with the risk of a slump "escalating through the year." The chances of a downturn in 1997 appear "better than 50%," he said.

The risk rises significantly a year from now, he said. "I would predict GDP growth of zero in the fourth quarter next year," he said.

"Almost every sector of the economy will be weaker next year than this year," he said. Consumer spending and capital investment will be slowing, as will government spending and export activity.

As for the housing sector, lower mortgage rates will help as the yield on the 30-year Treasury "long bond" nears 5% - from 6% now. But that boost will be countered by consumer concerns about jobs, income, and debt.

For reprint and licensing requests for this article, click here.
MORE FROM AMERICAN BANKER