Fed Won't Cut Rates to Help Markets Unless Liquidity Dries Up
By Michael McKee
New York, July 24 (Bloomberg) -- Investors shouldn't bet the Federal Reserve will cut interest rates to stem the slide in U.S. stock prices.
``The Fed intervenes when we are threatened with a liquidity crisis, which doesn't appear to be the case for the moment,'' said Diane Swonk, chief economist at Bank One Corp. in Chicago.
Since Alan Greenspan became Fed chairman in 1987, the Fed has reduced interest rates in response to the stock market only when the mechanisms for settling transactions and paying sellers failed. Greenspan has said central bankers don't need to reduce rates unless falling stock prices affect production, jobs, or price stability.
Jeffrey Applegate, Lehman Brothers Inc.'s chief investment strategist, is among the Wall Street executives who've recently said the lowest interest rates in 40 years aren't low enough to end a slump that's driven the Standard & Poor's 500 index down 19 percent over the past month.
A Bloomberg News survey of economists at the 22 securities firms that deal directly with the Fed found none of them expects the central bank to push the overnight bank lending rate below the current 1.75 percent.
Treasury securities have been rising as stock investors move their money into what they perceive to be a safer investment. That's pushing down yields, which should help stimulate the economy. ``That's doing more for the markets than the Fed could,'' said James Glassman, senior U.S. economist at J.P. Morgan Chase Securities in New York.
Falling Note Yields
The yield on the most actively traded 10-year Treasury note, a benchmark for home mortgage loans, fell 5 basis points to an eight-month low of 4.40 percent. The yields on two-year and five- year Treasury notes fell to the lowest level since the government began regular sales of the securities in the 1970s. A basis point equals 0.01 percentage point.
``A rate cut would be worse for the markets than doing nothing,'' Glassman said. ``For the Fed to ease at this point would be a signal they're losing confidence.''
Applegate said earlier this month that markets would ``have a hard time finding a firm footing'' if the Fed didn't lower rates. And others have said the Fed is risking deflation by letting asset prices fall too far, too fast.
``If disinflation becomes deflation, I have no doubt the Fed will have to act promptly'' to cut rates, said Miguel Sousa at Barclays Plc in Lisbon, which has about 1 billion euros in bonds under management.
Inflation
So far this year, the consumer price index is running at a 2.7 percent annual pace, compared with a 3.7 percent rate in the same period last year.
Fed funds futures, a barometer of expectations for the direction of interest rates, show that investors have begun to price in a chance the central bank will lower rates in the coming months. The November fed funds future has an implied yield of 1.66 percent, down from 1.74 percent last Thursday.
Last Sept. 17, as trading resumed following the terrorist attacks, the Fed cut the benchmark overnight rate by a half percentage point to 3 percent. In the days following the market crash of Oct. 19, 1987, the central bank essentially suspended any target for interest rates. And as trading dried up following Russia's default in late 1998, the Fed cut rates a total of three- quarters percentage point over three months.
In 1998, the New York Fed brought together 14 banks and securities firms, including Goldman, Sachs & Co. and J.P. Morgan & Co., to arrange the $3.6 billion takeover of Long-Term Capital Management LP, a Greenwich, Connecticut, hedge fund. Members of Congress criticized Fed officials for involving the central bank in the bailout.
Declining to Act
By contrast, the Fed declined to act Oct. 27, 1997, when the Dow Jones Industrial Average plummeted 554.26 points, or 7.18 percent, because brokers and dealers had no trouble completing trades.
Market participants say the payments system has functioned well over the past two weeks, through the biggest decline in stock prices since the crash of 1987.
One reason the system is working is that New York Stock Exchange specialist firms, which match buyers and sellers of designated securities, are larger and better-funded. Labranche & Co. has more than 10 times the amount of money for trading stocks that it had in 1987, said the firm's chairman and chief executive, Michael Labranche.
``There's much more capital in the marketplace, much more liquidity,'' said Labranche, whose firm is the largest on the NYSE floor.
`Irrational Exuberance'
Greenspan summed up the Fed's policy in his famous ``irrational exuberance'' speech of Dec. 5, 1996. After suggesting stocks might be overvalued, Greenspan said central bankers ``need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs and price stability.''
The Fed hasn't detected such a threat. Last week it raised its growth forecast for this year to as much as 3.75 percent, faster than the 2.5 percent to 3 percent foreseen in February. Retail sales rose 1.1 percent in June. Auto sales rose, as did home sales, which are on a record pace this year.
In addition, businesses appear to be spending again. Fed officials have said that a revival in business investment is necessary to solidify the recovery. The central bankers' twice- yearly economic report to Congress this month projected business investment in equipment and software rising during the second quarter, the first increase in a year.
``Spending in the business sector appears to have bottomed out recently,'' the Fed said.
Corporate Debt
Companies have issued less short-term corporate debt to finance inventories, which have fallen $260 billion since the recession began in March 2001, said Douglas Lee, president of Economics from Washington, a consulting firm. The drop in investment during the recession has helped corporations conserve cash. It has also reduced demand for loans, pushing banks to ease lending standards.
``Financial obstacles to new investment are not a problem,'' Lee said, ``so the threat a falling stock market poses to new investment is far smaller today than a year ago.''
Assuming a ``wealth effect'' on consumer spending, analysts said the Fed would be concerned if markets don't recover soon. People may become more reluctant to spend if the value of their portfolios drop. Economist Joseph Abate at Lehman Brothers estimates the cumulative market drop in the second quarter erased $3 trillion in household stock holdings.
``That alone will be enough to subtract 1.5 percent from GDP growth in the second half,'' Abate said.
Administration's View
Bush administration economists disagree. Glenn Hubbard, chairman of the president's Council of Economic Advisers, told Congress last week that growth would fall by 0.4 percent to 0.7 over a year if the recent stock market decline never reversed. ``That's a noticeable hit,'' Hubbard said. ``It by no means would derail the recovery.''
Greenspan told the House Financial Services Committee last week that people are more likely to base spending calculations on the value of their homes than on the value of stocks.
``So long as home wealth -- the value of homes and the equity we have in them -- continues to increase, that is clearly going to significantly temper the impact that the decline in stock prices has had,'' Greenspan said.
Since the beginning of the year, real estate wealth increased by $2.7 trillion, according to research by Merrill Lynch & Co. economists. ``The negative wealth effect from equities has so far been largely neutralized,'' said Merrill Lynch Chief Economist Bruce Steinberg. |
