Fed May Have to Lower Rates to Avoid Downturn

NEW YORK (Reuters) - A surprise drop in regional factory activity reported on Thursday suggested that the U.S. economy may be losing momentum faster than most economists anticipated, stunning financial markets on the view that the Federal Reserve may soon have to cut interest rates to avoid a downturn.

The sluggishness was also seen in a forward-looking economic gauge released early in the day, which hit its lowest level in nearly a year, sending fears of an economic slowdown through financial markets.

The yield on the benchmark 10-year Treasury note -- a proxy for how the bond market views the economy's long-term prospects -- sagged to six-month lows around 4.64 percent on the weakening data.

In the regional factory report, the Philadelphia Federal Reserve Bank said its business activity index tumbled to -0.4 in September from 18.5 in August, far below Wall Street economists' consensus forecast for a reading of 14.8. It was the first time the index had fallen below zero since April 2003. When the index turns negative, it means manufacturing is declining.

Even though the report's weakness clashed with signals from some other recent regional economic data, "generally the Philly data has the best correlation with industrial production of all the regional indices, so it needs to be treated seriously," said Alan Ruskin, chief international strategist with RBS Greenwich Capital.

The dollar dropped sharply on the report, extending its early-day losses and lifting the euro toward its biggest daily gain in about two months. U.S. stocks turned lower, with the Dow Jones industrial average down nearly 80 points.

Short-term U.S. interest rate futures shifted modestly lower after the Philadelphia Fed report to show a slight chance that the Fed might cut interest rates at its December policy-setting meeting if the economy continues to decelerate.

"We're seeing some potential moderation in inflation pressures. The (Philadelphia Fed report's) prices paid component decreased. This is good news for the Fed," said Gary Thayer, chief economist with A.G. Edwards and Sons in St. Louis, Missouri.

"It suggests that if the economy is cooling off, inflation pressures may also be subsiding," Thayer said. The trend suggests that "the Fed will probably hold rates steady for the foreseeable future and could perhaps cut interest rates early next year," he added.

Earlier, a report showed the number of U.S. workers filing new claims for jobless benefits rose slightly last week.

First-time claims for state unemployment insurance benefits rose to a seasonally adjusted 318,000 last week from an upwardly revised 311,000 in the prior week, the Labor Department said.

Separately, the New York-based
Conference Board said its index of leading economic indicators fell 0.2 percent to 137.6 in August -- the lowest since October 2005 -- after a downwardly revised 0.2 percent fall in July. It was the fourth decline in the past five months.

Another report also helped fill out a picture of a slowdown. The Chicago Federal Reserve Bank said its gauge of national economic activity fell to -0.18 in August from an upwardly revised -0.07 in July, weighed down by weaker production and employment indicators.

The Conference Board said the drop in its leading index signaled modest economic growth this fall and likely through the holiday season and into the winter.