The Fed Eases Up on the Gas
Wednesday June 27 02:50 PM EDT
SmartMoney.com
<<AFTER SIX MONTHS of chopping, Alan Greenspan (news - web sites) got out his paring knife on Wednesday. In a somewhat surprising departure from recent policy, the Federal Open Market Committee (news - web sites) cut interest rates by one-quarter point, rather than by the one-half point that many on Wall Street were expecting.
Specifically, Federal Reserve (news - web sites) policy makers reduced the benchmark federal-funds rate on overnight bank loans to 3.75% from 4.0%. They also lowered the more symbolic discount rate charged by the Federal Reserve to member banks by one-quarter point, to 3.25% from 3.5%.
Under Chairman Greenspan, the Fed has never lowered rates by so much in so short a time: In just six months, the central bank has dropped the fed-funds rate by 2.75%. During the 1990-91 recession, it took the Fed 17 months to cut as much.
But to investors who'd been counting on a bigger rate cut this month, that bit of trivia isn't much of a consolation prize. After rising modestly throughout the morning, stocks fell broadly, though the selling was restrained. At 2:30 p.m. ET, the Dow Jones Industrial Average was 37 points lower, while the Nasdaq Composite had fallen nine. The broader market, as measured by the Standard & Poor's 500 index lost eight.
The decision to forgo another half-point cut for a quarter-pointer may reflect a compromise between two increasingly divergent camps within the Federal Reserve. While some members of the FOMC have hinted that continued aggressive monetary action is needed to jump-start the intractable U.S. economy, an increasingly vocal contingent has been arguing that it's time to stand back and evaluate the impact of this year's rate-cutting campaign. In making additional adjustments, they've said, the Fed risks overstimulating the economy and reigniting inflationary pressures.
This week's batch of relatively positive economic data may have helped persuade the Fed to ease off the accelerator. The Conference Board (news - web sites) reported Tuesday that its survey of consumer confidence rose to its highest level this year in early June, as households reported improving expectations about economic conditions six months out (though little optimism about the current environment). Meantime, manufacturers' orders of durable goods rose by a more-than-expected 2.2% in May after plunging 5.5% in April, according to the Commerce Department (news - web sites). And sales of existing and new homes popped higher once again, despite continued erosion in unemployment and slightly higher mortgage rates.
While these reports, combined with dissension within Fed ranks, may have scuttled a sixth megasized rate cut, the dismal state of the economy undoubtedly remains the central bank's primary concern. In its policy statement, the FOMC reiterated its bias toward continued monetary easing, saying that the risks of recession still outweigh those of inflation. ``The patterns evident in recent months — declining profitability and business capital spending, weak expansion of consumption, and slowing growth abroad — continue to weigh on the economy,'' read the FOMC statement.
It's true the economy still shows few signs of resurgence despite all the aggressive action by the Fed. ``The fundamental [economic] landscape has not changed much,'' writes Goldman Sachs economist Bill Dudley. The manufacturing slump continues to deepen as cash-strapped businesses slash production and investment in capital equipment. And although consumer spending remains stable, there's still the risk that rising unemployment ``could lead to a fracturing of confidence that could lead to a full-blown recession,'' says Dudley.
Indeed, some economists now think gross domestic product, or GDP (news - web sites), may have contracted in the second quarter after expanding at a meager 1.3% pace in the first. The National Bureau of Economic Research, the official arbiter of the country's business cycles, said last Monday that that data ``indicate the possibility that a recession began recently.'' That was a stark departure from its April report, which stated ``nothing in the data is yet anywhere to the point that the bureau would investigate'' whether a recession had started. Whether or not we're technically in a recession, ``it's certainly going to feel like one,'' says David Jones, chief economist at Aubrey G. Lanston. ``Instead of two quarters of negative growth, we're talking about four quarters of extremely weak growth.''
The good news is that policy makers will have plenty of leeway to cut interest rates again because inflation pressures appear to be moderating as the economy slows. Indeed, on Wednesday, the FOMC reiterated its belief that easing labor and product cost pressures ``are expected to keep inflation contained.'' Though the easing cycle is probably close to finished, many economists expect the central bank to make one final cut in the fed-funds rate at its next meeting, on August 21.
Already, energy prices are starting to decline, and core inflation (which excludes food and energy prices) has fallen from a 2.8% rate in February to 2.5% in May. Granted, that's up from a trough of 1.9% in late 1999. But that's to be expected: Inflation usually rises going into an economic slowdown because tightness in the labor market takes time to unwind. In coming months, prices should continue to decelerate thanks to the combination of rising unemployment, cooling commodity prices and a strong dollar (which reduces the cost of imports). ``The element in our forecast we have the strongest conviction about,'' says Ed Hyman, chief economist at ISI Group and a SmartMoney.com pundit, ``is that inflation will slow significantly in the upcoming 12 months.''
But no matter how loose monetary policy ultimately becomes, there's a growing feeling among Wall Street economists — and at the Fed — that the economic rebound will be slow to start and then sluggish to progress. In past downturns, the economy has started to recover six to 12 months after the Fed begins lowering short-term interest rates. But according to a recent article in the Washington Post, some officials at the Fed are ``increasingly concerned'' that the economy isn't responding to lower interest rates the way it has historically.
Though looser monetary policy has stanched some of the bleeding in the stock market and encouraged a record amount of bond issuance, financial conditions are still inordinately tight. The dollar, which typically depreciates as interest rates fall, remains stubbornly strong, stymieing U.S. export growth. And bank loans — which still account for nearly one-third of lending — have barely grown since beginning of the year, compared with double-digit growth this time last year, says Mark Zandi, chief economist at West Chester, Pa.-based consultancy Economy.com.
Moreover, because companies are either nervous about the economic outlook or already invested to the hilt, they have little incentive to build new plants or upgrade old computer systems, no matter how accessible credit ultimately becomes. The old rule of thumb that it takes monetary policy up to a year to kick in may not apply in an economy held back by a severe drop in corporate spending, says Zandi. In this environment, ``there's no way to know with any conviction when Fed easing will begin to work,'' he says.
Patience is an old-fashioned virtue the New Economy must learn to live with.>> |
