The Drumbeat for a Downturn Deepens as Service-Sector Report, Richmond Fed Official Both Point to Recession

By Jason Simpkins
Associate Editor

U.S. stocks plunged yesterday (Tuesday) after a report said that January was the worst month for the American service sector in nearly five years and Federal Reserve Bank of Richmond President Jeffrey Lacker said the chances of a U.S. recession had risen.

All three of the key U.S. indices dropped about 3% yesterday.

The Institute for Supply Management announced that its non-manufacturing index, which reflects almost 90% of the economy, fell to 41.9 in January, down from 54.4 in December. A reading under 50 indicates an economic contraction.

"This is a stunning fall," Michael Moran, chief economist at Daiwa Securities America Inc., told Bloomberg News. "If accurate, it's dire news for the economy."

The decline was the largest in the survey's 10-year history and the first time since March 2003 it signaled a decline in service sector activity.

The ISM's index of new orders for non-manufacturing industries fell to 43.5, down from 53.9 in December. Its index of employment dropped to 43.9 from 51.8.

The Dow Jones Industrial Average plunged 370.03 points, or 2.93%, to close at 12,265.13. The broader Standard & Poor's 500 Index skidded 3.2%, dropping 44.18 points to close at 1,336.64. And the tech-laden Nasdaq Composite Index shed 73.28 points, or 3.08%, to finish the day at 2,309.57.

Lacker the Tracker

 During some prepared remarks made to banking leaders in Charleston, W.V., yesterday, Lacker, the Richmond Fed chief, said he sees "the possibility of a mild recession," and noted that additional interest-rate reductions may well be necessary.

"A slowing economy requires a lower inflation-adjusted interest rate," Lacker told his audience. The prominence of downside risks means that further easing may be warranted."

The comments represent quite a turnabout for Lacker, who has been one of the U.S. central bank's most vocal proponents of keeping inflation at bay. Indeed, in the last four U.S. Federal Reserve meetings of last year, Lacker dissented in favor of raising interest rates, according to a report by Bloomberg News.

 Butthe fact that he's so closely tracking downside risks to growth underscores that Fed officials believe that the odds of a sharp slowdown - if not an outright recession - are on the rise.

Contradictory Data

However, a report released by the ISM last Friday indicated that the U.S. manufacturing sector actually expanded in January. The group's manufacturing index rebounded to 50.7% for January, up from 48.4% in December.

"Startling, amazing, breathtaking. I cannot describe how unbelievable this report is," said Joel Naroff, president and chief economist of Naroff Economic Advisors in Holland, Penna. "It is hard to understand how the manufacturing sector could improve while services are collapsing."

But yesterday's disappointing report on the services sector seems to justify the recent spate of short-term-interest-rate reductions directed by Fed Chairman Ben S. Bernanke.

During the past two weeks, the policymaking Federal Open Market Committee (FOMC) has reduced rates by 125 basis points [or 1.25 percentage points] in a desperate attempt to keep the U.S. economy and securities markets afloat.

"If we take the report at face value, it would be hard to dispute that a recession, if not already here, is coming," Naroff said. "This report will likely spook investors, who could move further to the sidelines. And it could put additional pressure to get a fiscal package out and it might be even bigger than the House plan."

If the ISM data is supported by other figures, Naroff thinks another 50 basis point cut could be in the works. 

Economic growth slowed to an annual rate of 0.6% from October to December. Employers in January reduced payrolls for the first time in more than four years, the U.S. Labor Department reported last week. And consumers increased their spending at the weakest pace in six months in December, the year's peak shopping season.

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