Unsettling ideas about rate cuts
What if they don't boost the economy?
Jacqueline Thorpe
Financial Post
Monday, November 04, 2002
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As the U.S. Federal Reserve meets on Wednesday to consider cutting interest rates for the 12th time in this most perplexing of business cycles, the unsettling idea gaining ground is that another interest rate cut or two isn't going to cut it for the U.S. economy.
If interest rates at 40-year lows of 1.75% for the past 11 months aren't enough to ignite a solid and sustainable recovery, why should another 25 or 50 basis points make any difference, especially since the list of potential economic pitfalls seems to grow with each passing month?
Fears of a collapse in consumer spending, building deflationary forces and a lurking credit crunch -- the reason, some have surmised, the Fed may have triggered rate cut speculation in The Washington Post last weekend -- have recently got the upper hand on a burgeoning rally in the stock market.
While the rush of data released last week was not the complete washout analysts had feared -- growth of 3.1% in the third quarter being the highlight -- the overall impression was of an economy struggling to maintain its momentum.
"It's the feeling that the rate of growth we have seen is somehow unsustainable, that the pace of final demand has been disappointing and that consumers have done well but business has done nothing," said Ian Morris, chief U.S. economist at HSBC Securities USA Inc. in New York.
"The next two or three years are going to be positive growth but disappointingly low and insufficient to absorb new entrants into the labour market," he said. "So we may see a renewed increase in the unemployment rate next year and that's going to keep optimism well and truly down and out."
Mr. Morris expects a "growth rut" next year of little more than 1.5%.
The danger, however, is that the longer growth remains below about 3% the greater the chance that deflation, already percolating in the goods sector, will spill over into the service sector.
It is a tricky situation with which Alan Greenspan, as long and accomplished as the Federal Reserve chairman's career has been, has had little experience.
"The Fed's ability to avoid depression is a myth in the sense that experience with business cycles over the past half-century has demonstrated only the Fed's ability to end recessions of its own making, usually in pursuit of price stability," wrote John Makin, resident scholar at the American Enterprise Institute for Public Policy Research in Washington, in a recent paper.
"As yet no central bank has succeeded in mitigating the aftershocks of an investment-led cycle, in which overcapacity chronically depresses profits, as it did in the United States in the 1930s and Japan in the 1990s and has been doing again in the U.S. since early 2000," Mr. Makin wrote.
Of the three major worries dogging the economy at the moment -- consumers, credit and deflation -- the most immediate is the consumer.
The stunning drop in consumer confidence reported last week has stoked the view that U.S. consumers, sated by two years of non-stopping shopping and now worried about jobs, stocks and war, could finally turn their attention to rebuilding depleted savings .
That the consumer is only now showing signs of weakness two and a half years after the stock market bubble began to deflate is not unexpected, Mr. Makin said. Consumption in Japan held up for three years after its stock and property market bubbles burst, before dropping sharply.
Mr. Makin said there is a fundamental reason for this and it has to do with a familiar theme in investing -- opportunity cost. The cost of spending on luxury goods was high when gains to be had from investing in the stock market were high. When stock prices plummeted, the opportunity cost of spending went down, even though households were losing wealth.
Mortgage refinancing at attractive interest rates helped that process along, but now the negative wealth effect from declining stock markets has become too big to ignore, he said.
The hope was that the business sector would come to the economy's rescue before the consumer began to wilt. And while last Thursday's third-quarter GDP showed business spending on equipment and software rose for the second consecutive quarter, analysts say industry has a long way to go before it is operating near a pace where it can invest and hire at appreciable levels.
"Everybody says business capital spending has to pick up. Well, heck, we're operating at a 74% capacity utilization rate and the Chinese are eating our lunch, so why should business spending pick up?" asked Donald Coxe, chairman of Harris Investment Management Inc. in Chicago. "Every businessman I've talked to says I can't compete or if I'm going to do any capital spending I'm going to do it in China."
The other major worry for the business sector concerns credit. Corporate-bond yields have sprung out recently against U.S. treasuries, a signal that both lenders and investors are becoming wary about the ability of companies to meet their obligations. Banks are still trying to swallow massive loans to the telecom and energy sector that have gone bad.
"[What] you need at a time like this, when loans are being written down because of bad decisions in the past, is really good credit demand from worthy borrowers on the other side to offset, so you've got money moving out of the system, and we're not getting that at the moment," Mr. Coxe said.
"There's not a lot of evidence of somebody coming up with bright new ideas for useful applications of capital, which means the economy is doing very little of anything."
Mr. Morris at HSBC USA said credit concerns could be one reason the Fed decided to foment a little rate-cut speculation in The Washington Post and The Wall Street Journal last weekend.
"They might know something we don't know -- a risk of a corporate crunch or a severe tightening of lending standards," he said. "Or they could be worried about the deterioration of corporate-bond trading."
Whether it is the consumer, unemployment, credit or deflation, analysts said Friday's data sealed a 25 basis point cut from the Fed and maybe a 50 basis point reduction.
None too soon, according to Mr. Makin at the American Enterprise Institute.
Faith that the Fed could fix the U.S. economy with interest rate cuts after the investment bust -- just as central banks have controlled inflation in the past with rate rises -- probably lulled it into a sense of complacency, he said. In short, the Fed has not acted aggressively enough.
Mr. Greenspan needs to reaffirm price stability as the primary target of monetary policy, he added.
"If the conviction to avoid deflation is as strong as the conviction to avoid inflation, while business cycles won't disappear, the risk of depression after stock-market bubbles will be greatly reduced," he said.
Mr. Makin is certainly more pessimistic than most analysts, but there is a fear that even a 50 basis point cut will not be enough to get the economy going again.
"The closer you get to zero, it's generally felt the less effective monetary policy is, because the economy may have fallen into a liquidity trap," Mr. Morris said.
People hold on to their cash because bonds don't pay very much and stocks are too risky. "The Fed may be pumping lots of liquidity into the system at zero interest rates, but if it's only going under the mattresses of consumers and not being spent it does nothing to boost output or nothing to reduce the unemployment rate," he said.
Russell Sheldon, senior economist at BMO Nesbitt Burns, said, however, there are still 175 basis points before the Fed reaches zero.
Even after 475 basis points of cuts last year, the real Fed funds rate -- borrowing costs adjusted for inflation -- is still only barely negative when using Mr. Greenspan's favourite inflation gauge, the "smoothed core personal consumption expenditure deflator."
That inflation measure is at 1.82%, giving a real Fed funds rate of just -0.07%, compared with a low of -1% after the early 1990s recession, when the wobbly economy finally caught a spark and began to fully recover. "There is no emergency," Mr. Sheldon said. "Instead, we are watching the maestro orchestrating the conclusion to his long-running symphony."
Let's hope Mr. Greenspan picks up the tempo soon.
jthorpe@nationalpost.com
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