The Fed Bows Out Of The Picture
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June 28, 2001 - Yesterday's announcement from the Federal Reserve on
interest rates was remarkable in that it contained nothing positive for
investors.
The Fed cut the Fed funds and discount rates by only 25 basis points each,
ending a string of five 50-basis point rate cuts. At the same time, the
accompanying statement contained none of the positives, such as strong
consumer confidence and home sales, included in other recent statements.
And the Fed gave no hint this time that it is willing to cut rates between
meetings.
"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," the FOMC said. "The
associated easing of pressures on labor and product markets are expected
to keep inflation contained."
That statement - a weak economy coupled with low inflation pressures -
seems to argue for another 50 basis point rate cut. So why didn't the Fed
deliver?
One answer is that the Fed's inflation hawks, who have become more vocal
in recent weeks, are beginning to assert themselves. Some FOMC members
have expressed concern that the Fed's aggressive rate-cutting could spark
inflation. Yesterday's 25-basis point discount reduction was requested by
only seven of the 12 regional banks, which have been concerned about the
50-basis point actions pushed by Chairman Alan Greenspan.
Another answer is that the Fed is simply running out of room to cut rates.
The 3.75% Fed funds rate and 3.25% discount rate aren't too far from the
3% level reached on both rates in 1992-1993. The Fed wants to hold back
something in case the economy remains persistently weak or worsens, and to
go lower than 3% would take short-term interest rates below the rate of
inflation and to a level not seen in 40 years.
The third reason is that the Fed probably wants to give the 275-basis
points in rate cuts since the start of the year time to work. As we
pointed out two days ago, businesses have a tendency to put off new
investments during Fed rate-cutting cycles in the hope that rates will get
even lower. By signaling an end to the most aggressive part of the easing
cycle, businesses could be forced to implement delayed capital spending
plans. And right now is about when the first rate cuts should be starting
to be felt.
But whatever the reason - and all of the above likely played into the
decision - the result is that the Fed has now removed itself from the
picture. Investors will now be watching the economy and corporate earnings
for signs that the rate cuts are beginning to work. Two straight declines
in weekly jobless claims and stronger than expected durable orders and
consumer confidence are a start, but a rebound in economic readings in
February turned out to be a blip in a bigger downtrend. It will take more
than a week of data to signal that the bottom for the economy is in. And
technology and manufacturing remain mired in recession.
In the short run, the Fed's admission that things are bad and that it has
done about all it can do to help might spark one of those perverse market
rallies that tend to occur after all the bad news is out. But for any
gains to be sustained, the economy and corporate earnings will have to
begin to show improvement. |
