Fed Wonders: Where's the Rebound?
Policymakers Worried by Economy's Unusual Resistance to Rate Cuts
By John M. Berry
Washington Post Staff Writer
Thursday, June 21, 2001; Page A01
As U.S. economic growth remains stubbornly sluggish, some Federal Reserve officials are growing increasingly concerned that unusual developments may be clogging the main channels through which lower interest rates normally stimulate the economy.
After five half-percentage-point rate cuts this year -- the most aggressive such actions by the central bank in nearly 19 years -- there is no sign yet of a rebound.
Fed officials believe their policy actions will eventually be effective, but, because of a variety of factors, they can't be sure when. That makes it more difficult for them to decide whether, and by how much, to cut interest rates again when the central bank's top policymaking group, the Federal Open Market Committee (FOMC), meets next Tuesday and Wednesday.
There's always a long lag between changes in interest rates and noticeable changes in the economy's behavior. For that reason, the impact of the first of the interest rate cuts this year, which came Jan. 3, ought to be just beginning to be felt.
But some Fed officials are becoming increasingly concerned that any rebound in growth might not begin until next year and that it could start out weaker than many investors and analysts are expecting.
That's because they see few signs that the economy is responding to interest rate cuts in traditional ways.
First, when the Fed cuts rates, the value of the dollar usually falls, making U.S. exports cheaper for foreign buyers and thus stimulating U.S. production. But that hasn't happened this year. The dollar has kept rising, and exporters are furious.
Second, lower rates usually give the stock market a boost, which can stimulate consumer spending as household wealth increases. But stock prices have remained stubbornly weak, particularly for high-tech companies whose share prices have plummeted from their speculative peaks of more than a year ago.
Third, short-term rate reductions usually also bring down longer-term rates, which encourages businesses to invest more in new plants and equipment because it is less costly to borrow. But many companies have a large inventory of unsold goods, and high-tech manufacturing firms in particular have lots of excess production capacity because of the investment boom that ended last year. Companies in such straits are not likely to increase their capital spending simply because interest rates have fallen. Moreover, long-term rates have dropped only modestly so far.
These factors have "blunted the power of monetary policy compared to past easing campaigns," Goldman Sachs Group Inc. told its clients last week.
One area where Fed actions have helped has been in holding down mortgage rates, which has contributed to the still-strong housing market.
But Fed officials concede that further rate cuts won't boost business investment under these circumstances, and they have no confidence that more rate cuts will cause the dollar to weaken. And as long as business profits are falling, the stock market isn't likely to stage a sustained rally.
In a speech last week, Robert T. Parry, president of the San Francisco Federal Reserve Bank, said that after years of high levels of investment "many firms seem to have large stocks of capital equipment already, so they're not in the market for more."
Another factor to consider is that federal income taxes are being cut and many American households next month will begin getting advance refund checks of up to $600, some of which likely will be spent quickly, giving the economy a temporary shot in the arm. A number of Fed officials, however, do not believe the tax cut will have a significant impact on the economy.
So the goal of many of the Fed policymakers is to try to provide enough of a cushion through lower rates to keep the economy out of a recession until businesses are able to work off their excess inventories and absorb all the spare production capacity they've created.
The issue on the FOMC table next week will be to decide, in essence, how much is enough. That's the sort of judgment call that often leads to difficult meetings and compromise outcomes at the consensus-seeking FOMC.
Although the primary focus of the FOMC members remains the weak economy, some on the committee have also expressed concerns that rates could be reduced so far that inflationary pressures would rise when economic growth picks up later this year or in 2002. A few members may well be arguing for a pause in the rate-cutting campaign.
Worst of all, there is growing worry that whatever the Fed does, it might not be enough -- that before the stimulus from the rate reductions and the tax cut kick in, the economy could still tip into a recession.
Since last fall, the nation's unemployment rate has gone up about half a percentage point, to 4.4 percent, and the number of workers with jobs is slowly shrinking. So far job worries have not caused consumers to reduce their overall spending, but spending is rising only very slowly.
That could change quickly, as Anthony Santomero, president of the Philadelphia Federal Reserve Bank, said in a recent speech.
"I believe that now the most significant risk factor is the timing of the impact of the policy actions already taken," Santomero said. "In essence, I think there is something of a footrace going on. Will the stimulative monetary and fiscal policy actions we have undertaken provide enough upward momentum in time to offset the potentially cumulating downward momentum of a weakening labor market?
"I believe the answer is yes. But there remains the risk that they will not," Santomero said.
Many investors and financial analysts expect the Fed to reduce rates again next week. Until last week, most expected only a quarter-percentage-point cut in the FOMC's target for overnight interest rates, to 3.75 percent. That would put the target 2.75 percentage points lower than its 6.5 percent level at the beginning of the year.
But a shower of bad economic news last week has caused many investors and analysts to decide the Fed is more likely to cut the target by another half-point, to 3.5 percent.
If the committee decides on a quarter-point cut, that could be a compromise choice. Either way, the FOMC is expected to issue a statement at the close of the meeting saying the members continue to regard the risk of additional economic weakness as outweighing the risk of more inflation -- in other words, that the rates cuts aren't necessarily over.
Unfortunately, in all likelihood, the outcome of the economic footrace won't be determined by the FOMC's decision next week. Given the inevitable lags, any change in rates now will have little if any impact on economic growth until the beginning of 2002, Fed officials say. The issue is what the state of the economy will be six months or more from now, and, as Santomero said, that depends on how effective the stimulus already in place turns out to be.
And that is where the concern about future inflation comes into play. Some worry that additional rate cuts now could fuel inflation pressures months from now, after the economy has revived.
Fed Governor Laurence H. Meyer said in a speech late last month:
"We have been quick and aggressive in responding to what we viewed as a threat of a slowdown that was steeper than necessary to contain inflation, and the risks remain tilted in that direction," Meyer said. He added: "Attention must also be given to calibrating the [rate reductions] to avoid overshooting in the other direction in a way that ends up adding to price pressures as growth strengthens."
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