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Is the Fed done?

For the second time this year, Federal Reserve policymakers left interest rates unchanged Tuesday, holding the key short-term rate at 6.5%. That fanned expectations that Fed officials believe their six rate increases since June 1999 have slowed the economy enough to ward off inflation.

But economists are divided over whether the Fed is through raising interest rates, chiefly because no one knows for certain whether the current slowdown is a lasting deceleration or just a pause.

The stakes are large, because a certainty that the slowdown is real and the Fed is done could reignite stock markets. Markets have slumped since the Fed signaled in the spring that it would raise rates until it got the economic soft landing it badly wanted.

Analysts who think the Fed is through got what they think is strong evidence in Tuesday's Fed statement. While the Fed reissued its longstanding warning that the risks still tilt in the direction of higher inflation, Fed watchers detected an unusual bullishness in the carefully worded statement that officials release after every meeting.

The Fed has complained for months that supply and demand are out of whack, a key risk for inflation. After leaving rates unchanged at the June meeting, the Fed said demand "may be moderating" to a pace more in step with supply, but that signs of slowing were "tentative and preliminary."

On Tuesday, the Fed axed the "tentative and preliminary" language and said definitively that demand "is" moderating. And for the first time, the statement added that big productivity increases in American business -- in which companies find ways to produce more output for every hour worked -- have raised the economy's speed limit. Fed decryption experts say such changes in the tea leaves are a huge deal.

"These are tea leaves that landed in big bold letters," says Louis Crandall, chief economist for Wrightson Associates and a longtime decoder of Fed statements. The switch from "may be" to "is" was a sign that the Fed is increasingly confident that economic data show that the much-hoped-for "soft landing" is the real thing, not just a low pass over the runway before the economy takes off again.

Although Crandall personally believes the Fed has more rate increases up its sleeve eventually, he thinks the statement is an important signal that it would take a lot of bad economic news to get the Fed off the sidelines in the short run.

The Fed statement echoes a similarly upbeat assessment by Fed Chairman Alan Greenspan, who told Congress in July that while the slowdown might be just a pause, there were several reasons to suspect it would be longer-lasting.

Many economists took that as confirmation Greenspan was seeing the same things they were in the economic data. Consumer spending has slowed sharply since last winter, housing construction has moderated and economic growth is showing signs of cooling.

Although the labor market remains extremely tight, there are continuing signs that companies are finding ways to cope without bidding up wages so high that they ignite inflation. Furthermore, stellar gains in productivity have helped companies absorb higher wages without raising prices to consumers.

A classic soft landing?

This certainly looks like the textbook definition of a soft landing, in which the Fed cools a too-hot economy just enough to dampen inflationary fires, but not so much that the nation tips into recession. If we're there, the Fed has made its last rate increase for a long time.

"I believe that they're done," says Bruce Steinberg, the chief economist for Merrill Lynch. "The economy has achieved most of the things they want it to achieve," he says, noting that growth has moderated and inflation remains tame. "As long as those two things remain true, they don't have to do anything more."

Although a lot of economists have joined Steinberg since he first declared the Fed done in early June, that's still a minority view. While almost no one thinks the Fed will raise rates at its next meeting Oct. 3, just weeks before the November elections, a slight majority believe Greenspan and his colleagues will bump rates up at least an additional quarter-point later this year or sometime next year.

A survey by the National Association for Business Economics found 53% of respondents believe that the Fed will raise rates again in the next six months. And in a survey by the consulting firm Stone & McCarthy Research Associates, 56% of Fed watchers forecast that the Fed will bump rates up by at least an additional quarter-point before the end of the year.

"Clearly the economy has slowed down -- there's no question about that," says Ray Stone of Stone & McCarthy. "The question does remain, though, whether this is a pause or whether it's going to show some sign of reacceleration."

Stone and others who believe the economy could take off again this fall point to at least two major reasons:

* Broad interest rates haven't kept up with the Fed's increases, which makes it easier for consumers and businesses to borrow -- and spend -- money than the Fed might prefer. While the prime rate has moved in lockstep with the Fed, carrying with it home-equity loans and other loans indexed to the prime, other key rates have barely budged.

The Fed has raised the short-term federal funds rate, the rate banks charge one another for overnight loans, by 1.75 percentage points since June 1999. But 30-year mortgage rates have fallen back below 8%, barely higher than they were when the Fed began its work last year. Some key corporate loan rates have risen, but not nearly as much as the federal funds rate.

* The stock market, which tanked badly in the spring, has shown signs of life since the conviction spread that the Fed might be nearing the end of its tightening cycle.

"The farther away we are from what appeared to be a bloodbath," the more confidence builds that the market could return to something approaching its remarkable gains of last year and early this year, Stone says. "Combine that with lower market interest rates, and you could make the case (that there is) a risk to consumer spending on the stronger side."

Keeping an eye on consumers

Wrightson economist Crandall says consumers, whose spending accounts for about two-thirds of economic growth, are the key. "The Fed will be forced to tighten more if we see any buoyancy in spending this fall," he says.

The signs of that are ambiguous. After languishing in the spring and early summer, retail sales shot up a surprising 0.7% in July. Pessimists viewed that as the leading edge of a consumer rally that could spook the Fed. Optimists said it was merely a healthy return to more normal spending after a serious slowdown.

Merrill Lynch's Steinberg says even at that rate, consumer spending would be only about half what it was last winter, and he dismisses the fears of colleagues who claim to see signs of a reaccelerating economy. "I don't know what they're looking at," he says.

Other economists say that what they fear most is that a too-tight labor market will eventually drive up wages enough to force companies to begin raising prices. That is a classic recipe for an outbreak of inflation, but it's also a theory that has gone from ironclad economic rule to debatable theory as the unemployment rate has hung near its 30-year low for months without triggering an upsurge in prices.

Diane Swonk, chief economist for Bank One, says that wage pressures are creeping up, and that if they get out of hand, even the economy's remarkable productivity gains won't be enough to offset them. "Once wages start rising, they don't stop. Wages can double overnight; productivity cannot," she says.

Swonk's fear is one that Greenspan has mentioned repeatedly, but his actions suggest he doesn't think it's nearly as serious a worry as Swonk does. Greenspan has battled Fed hawks who would have preferred more aggressive interest rate increases in the face of low unemployment, and he recently told Congress that the current 4% unemployment can continue without igniting inflation.

Help from the 'new economy'

The Fed's statement Tuesday cautioned that the rate at which the economy is soaking up available workers "remains at an unusually high level." But it also said that the economy's productivity gains are "containing costs and holding down underlying price pressures."

Sounds as if the "new economy" has helped the Fed glide the economy to a soft landing with hardly any pain at all. But even optimists caution not to get carried away.

"Whoa, there, partner -- we are just at the beginning of this process," says Ken Mayland of Clear View Economics. Mayland notes that the Fed's last rate increase, an unusually aggressive half- point in May, is still rippling through the economy. The lag between what the Fed does and when it socks consumers and businesses can be a year or more.

"We may now only be beginning to enter that soft landing," Mayland says.