The Economy
Is the Fed Flummoxed?
By Rebecca Thomas
June 21, 2001
The Rate Depression
Data from November 1999 to May 2001
THINGS AREN'T happening the way they're supposed to.
We're six months into the Federal Reserve's aggressive campaign to stimulate economic growth with lower interest rates, and the economy is getting worse, not better. Has the central bank lost its magic? Are policy makers powerless?
That will likely be Topic No. 1 when the Federal Open Market Committee, or FOMC, meets next Tuesday and Wednesday to decide whether to cut interest rates for the sixth time this year. Although policy makers are widely expected to lower the benchmark federal-funds rate below the current level of 4.0%, Wall Street remains divided over the size of the reduction.
Understandably so, given that Fed policy makers themselves are reportedly having doubts about the efficacy of their monetary tools. According to Thursday's Washington Post, some officials at the Fed are growing "increasingly concerned" that the economy isn't responding to lower interest rates the way it has historically.
The concern — which is shared by many Wall Street economists — seems to be that the economic rebound will be slow to start and then sluggish to progress, no matter how loose monetary policy becomes. The problem? Unlike in the past, the current boom-bust cycle has been led by the business sector, rather than by the consumer. Businesses (particularly technology companies) are sharply pulling back on investment spending as they struggle to work off excess capacity and bloated inventories. Consumers, meanwhile, have slowed their spending somewhat, but continue to make big-ticket purchases — against all predictions.
This presents a problem for the Fed because the link between interest rates and business spending isn't as clear-cut as the link between easier monetary policy and consumption. When the Fed reduces short-term interest rates, financial instruments like mortgages and auto loans become more affordable, increasing the average consumer's incentive to borrow and spend. And because consumer spending accounts for two-thirds of gross domestic product, or GDP, the economy usually starts to recover after a lag period of around six to 12 months.
A Different Kind of Downturn
But that rule of thumb may not apply in an economy held back by a severe drop in corporate spending, says Mark Zandi, chief economist at West Chester, Pa.-based consultancy Economy.com. Although easier monetary policy certainly induces lenders to provide more business financing at cheaper rates — which can help profits — companies that are nervous about the economic outlook or already invested to the hilt have little incentive to build new plants or upgrade old computer systems, no matter how accessible credit becomes. In this environment, "there's no way to know with any conviction when Fed easing will begin to work," he says.
Frustrated, the Fed has been lowering interest rates far more quickly and aggressively than it has in the past, cutting the benchmark fed-funds rate by 2.5 percentage points in only six months. Moreover, the central bank has the support of the federal government, which is sending out tax rebates this fall in an attempt to stimulate demand. The Fed's hope is that the combination of looser fiscal and monetary policies will provide a boost big enough to help businesses work off excess inventories and absorb spare capacity.
That should happen eventually, but it may take longer than economists have been predicting. For the moment business confidence and capital spending continue to plummet, especially in areas such as technology where there's been significant overinvestment and overexpansion spurred on by years of easy money in the capital markets. Consider the plight of the telecom industry. Over the past several years, the sector has undergone a massive buildout of broadband capacity in anticipation of booming Internet demand for data. But because only 5% of the 100 million miles of fiber-optic cable in the ground is being used, spending has come to a screeching halt. "Lower rates aren't going to get you one more order for fiber-optic gear," says Salomon Smith Barney economist Steven Wieting. "It doesn't make a bad investment a good one."
Yet because the telecom industry's role in the overall economy has become so significant, its rapid decline is exerting a significant drag. Economy.com economist James Glen estimates that the recent abrupt pullback in telecom-equipment spending shaved 0.4% off of first-quarter GDP (which expanded at just 1.3%) and will "continue to weigh on what little is left of the expansion." Moreover, the telecom implosion may have an indirect impact on consumer confidence and spending if profit-strapped companies continue to lay off employees.
Quarter Point or Half Point
Which brings us back to the Fed meeting. While some members of the FOMC appear to think deeper cuts are needed to stimulate the most reluctant corners of the business sector, an increasingly vocal contingent of Fed officials has begun to question that logic. Their argument: It's time to stand back and evaluate the impact of this year's already drastic rate cutting. The risk, they say, is that the Fed may overstimulate the consumer economy in an attempt to boost the business sector. And when the business recovery inevitably comes, the combination might rekindle inflationary pressures in the process. With inflation all but dormant, however, that's a minority view. The pressure is on to continue cutting rates aggressively by a half, rather than quarter, point.
In the meantime, there's no reason to panic. In the end, the technology sector will recover on its own, albeit slowly. After all, equipment depreciates rather quickly and becomes obsolete as soon as new, improved products hit the market. Moreover, because information technology has facilitated "just in time" inventory rebalancing, companies should be able ramp up investment quickly once they make the decision to do so.
Moreover, monetary policy is already doing — and will continue to do — much good in areas of the economy outside of technology. Lower mortgage rates, for example, are keeping the construction and housing markets afloat, helping to ensure that the manufacturing recession doesn't spill over into the consumer economy. For the 12 months ended in April, total home sales grew by 0.2% year over year, compared with a 9.2% annual decline during the recession-plagued 12 months ended March 1991, according to Moody's Investors Service. Fannie Mae estimates that mortgage-refinancing activity will likely pump an additional $40 billion into the economy this year as people take the money they save on their mortgages and spend it on furniture and appliances.
Moreover, lower interest rates should encourage investment by Old Economy industries (think energy and utilities) with product shortages rather than capacity gluts, says Wieting. Already, access to short-term credit has improved admirably in response to the Fed's reduction in interest rates this year: Moody's reports that investment-grade bond issuance reached a record $94.2 billion in May — a rise of 72% from a year ago — while junk bonds brought in $12.7 billion, or 162% more than a year ago.
Also, because the cost of borrowing has fallen substantially, companies are expected to begin refinancing outstanding debt. The benchmark short-term variable borrowing rate — the London interbank offered rate, or Libor — has fallen about three percentage points since October to 3.75%. If corporate America refinanced the $1.86 trillion in outstanding short-term debt in the first quarter, it could theoretically save $56 billion, says John Lonski, chief economist at Moody's Investors Service. And any savings, of course, will only buoy profits by helping to offset energy and labor costs.
Of course, none of this minimizes the seriousness of the problem in technology. But if lower interest rates succeed in spurring the Old Economy before the New Economy recession spreads, the Fed will have succeeded. "The idea that the Fed is impotent — or pushing on a string — has come up in every recession," says David Orr, chief economist at First Union Capital Markets. "It's never been correct." |
