Fed May Cut Interest Below Inflation Rate, Reaching Lowest Level Since Kennedy Era
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
WASHINGTON -- The Federal Reserve Tuesday could reduce interest rates below the inflation rate for the first time in almost eight years.
The question is: Would the cut do too little or too much to boost the economy?
The Fed is widely expected to reduce its target for the federal-funds rate from 3%, with most analysts expecting a half point cut to 2.5%. Even with a quarter-point cut, the rate would be the lowest since the Kennedy administration.
Either way, the new target rate would be at or below August's 2.7% inflation rate, excluding volatile food and energy prices. That would make the "real" interest rate, considered a better indicator of monetary stimulus than unadjusted rates, zero or slightly negative.
The last time that happened was from early 1992 until the end of 1993. Market rates such as the two-year bond yield suggest investors believe the real federal-funds rate will be at zero for some time to come.
See the full text of the September survey from the National Association of Purchasing Management.
The Sept. 11 terrorist attacks have forced the Fed to take a much more aggressive stance than before. At the time, the economy was close to recession, but Fed officials had seen some positive signs. Consumer spending, bolstered by $40 billion in tax rebates, held up well into early September.
Monday, the Commerce Department reported personal consumption rose 0.2% in August from July, even though incomes, depressed by job losses, didn't grow. The hard-hit manufacturing sector also showed signs of having hit bottom. Monday, the National Association of Purchasing Management said its index of manufacturing activity declined only slightly, to 47 in September from 47.9 in August. That suggested that while manufacturing shrank for the 14th straight month, it did so at a much slower rate than earlier in the year, and the production and new-order components actually signaled modest expansion.
See the full text of the Commerce Department's report on August personal income and spending.
Norbert Ore, chairman of the purchasing-management association's survey committee, said a "significant majority" of responses to the survey came in after Sept. 11, but he said most respondents didn't know what impact the attack would have on their business. "October will give a much better sense," he said.
The terrorist attacks have prompted almost everyone, including Fed officials, to up the odds that the economy would contract, and the Fed wasted no time in responding to that threat. It slashed the federal-funds rate, charged on overnight loans between banks, to 3% from 3.5% the Monday after the attack and signaled it was ready to do more. Indeed, markets anticipate the funds rate will be 2.25% by year's end.
But some analysts worry that rates, no matter how low, might not stimulate spending when consumers are worried about their jobs, and businesses are stuck with too much capacity. Indeed, the Commerce Department reported construction spending sank 1.1% in August, mostly because of plunging commercial construction, after falling 0.8% in July (revised from an initial estimate of a 0.1% decline).
"Monetary policy works by making someone in the private sector borrow money," said Paul McCulley, economist and fund manager at Pacific Investment Management Co., Newport Beach, Calif. But "monetary policy simply doesn't have the potency it did prior to the bubble in business investment and certainly doesn't have the potency it did prior to Sept. 11."
The one area clearly kept afloat by lower rates is housing, and that may be at risk: Mortgage applications to buy homes have slumped since the attack, though refinancing applications have shot up. Car sales, also sensitive to financing costs, were expected to fall in September, even before the attacks.
If housing and auto sales don't recover by October, "it would tell me the confidence decline is trumping lower interest rates," said William Dudley, head of U.S. economic research at Goldman Sachs. Both Mr. McCulley and Mr. Dudley believe that a big dose of government spending or tax cuts is needed to complement the Fed's actions.
Others seem just as worried that policy makers may go too far. Fed Chairman Alan Greenspan has cautioned Washington about the risks of spending so much of the budget surplus that long-term rates go higher. Ignazio Visco, chief economist of the Organization for Economic Cooperation and Development, representing industrialized countries, said that while aggressive easing of monetary and fiscal policies will support demand now, "they could rekindle inflationary pressures and require a sharp policy tightening in 2003."
Mickey Levy, chief economist at Bank of America, said the signs point to an extraordinarily stimulative central bank: a zero short-term interest rate, 10- and 30-year bond yields remaining steeply higher than overnight rates, and a ballooning money supply. "Along with the huge increase in government purchases, the risk of inflation pressures over the long run have clearly risen," he said. |
