Anticipated rate cut by Fed only adding to 'weird' climate
By David A. Sylvester / San Jose Mercury News / June 24, 2003
After cutting interest rates 12 times over the past 2 1/2 years, the Federal Reserve is poised to take the U.S. economy into a kind of Twilight Zone: interest rates of 1 percent or less.
The Fed's historic binge of rate-cutting has produced the strange world of 0 percent automobile loan financing, 30-year fixed mortgage rates dropping toward 5 percent, and rates on savings deposits settling down to 1 percent and less.
At the same time, the Fed's efforts have had only modest impact as the U.S. economy -- and Silicon Valley especially -- is stuck in a weak recovery with stubborn unemployment. Is it possible that the post-bubble economy may not react to the Fed's stimulus as it once did? Will a 13th rate cut do what the previous cuts did not? Are soaring bond prices creating a new bubble?
Even financial market veterans feel a general sense of unease in the topsy-turvy times.
``This is the weirdest environment I've ever seen,'' said Joe Corona, chief market trader at Dynamic Hedge fund managed with legendary stock options expert Anthony Saliba in Chicago. ``It feels the way it feels when a tornado is forming. It gets quiet and the sky turns dark and everything is greenish. It feels weird.''
With the Federal Reserve beginning two days of meetings today, stock market investors played it safe and took profits Monday on the three-month rally. The tech-heavy Nasdaq composite index dropped 33.97, or 2.1 percent, to 1,610.75, after rising last week. The broader Standard & Poor's 500 index fell 14.05, or 1.4 percent, to 981.64, and the Dow Jones industrials were down 127.80, or 1.4 percent, at 9,072.95.
Reasons for cut
Analysts have watched the emerging rally in stocks nervously since many investors seem to be returning more quickly than expected and apparently are less concerned about the chance of a sharp decline.
The Fed meeting is coming as optimism in the stock market contrasts with the recent worries about deflation. It's also a time when the Fed is loosening monetary policy to make it easier to borrow and is more concerned about irrational pessimism than what Greenspan once called ``irrational exuberance.''
Two weeks ago, Greenspan hinted that the Fed might need more ``insurance'' against deflation, which most analysts assumed meant another rate cut. Analysts expect at least a quarter-point cut and possibly a half-point, scheduled to be announced Wednesday.
A quarter-point cut would reduce the federal funds rate -- the rate at which banks lend to each other overnight -- from 1.25 percent to 1 percent. Already, yields on the 30-day Treasury bill have dropped to 0.8 percent.
By lowering the interest rate below the rate of inflation, the Fed is punishing people who hang onto cash instead of investing. As the short-term interest rate drops, it has a widespread effect on everything from credit card loans to banking deposits. In theory, loans should become cheaper for consumers, making it more economical to buy more goods and services.
But some doubt it will. ``I don't think this will motivate people to run out and borrow money that they weren't about to borrow anyway,'' says Ken Fisher, president of Fisher Investments in Woodside who accurately forecast the stock market's current rally.
In addition, with rates headed so low, it's possible that banks and credit card companies may stop being able to cut rates and still cover their basic costs of operating. Some are concerned that squeeze may develop for money market accounts operated by mutual funds, since the costs to operate these funds can exceed 0.75 percent or 1 percent.
``As you get toward zero, you can only go so much lower,'' says Gary Schlossberg, senior economist at Wells Capital Management in San Francisco.
At the same time, retired investors who depended on high-yield certificates of deposits may find their income shrinking or may be forced to switch to U.S. Treasury bonds where they can obtain some gain in prices if yields keep dropping.
Homeowners already have had a bonanza in refinancing their mortgages as long-term rates dropped over the past two months.
Impact of cuts
Dubbed the ``Open Mouth'' policy of getting long-term rates to decline, the Fed has convinced the bond market that lower rates will stay for some time. The yield on the 30-year Treasury bond, which is closest to the market where mortgage rates are decided, has dropped to 4.4 percent.
With all this stimulation to the economy already, it may seem only a question of time before the recovery becomes stronger. But some more pessimistic economists are worried that the Fed's efforts are backfiring and creating new bubbles in the mortgage market and the bond market.
Stephen Roach, chief economist at Morgan Stanley, calls the Fed a ``serial bubble blower'' because he believes the central bank has been too aggressive in attempting to keep the U.S. economy out of trouble.
The real question is whether the Fed's aggressive action will set the stage for a revival of inflation later. Some economists would like to see a return of what might be called ``good inflation.'' That's when prices are rising enough so that businesses can cover increased costs and keep their profits healthy, allowing them to expand and hire more employees later.
Fisher worries more about inflation because the Fed is printing money at a faster rate than the overall economy is expanding. Generally, when more money is available to chase fewer goods, it drives up the price level for goods.
``Inflation is a much higher risk down the road,'' Fisher says. ``Eventually it will happen. The question is when.'' |
