Are rate cuts the right cure?
Irwin Stelzer from the Times (London)
ALAN GREENSPAN and his colleagues on the Federal Reserve Board's monetary policy committee certainly created a drama last week when they announced an inter-meeting interest-rate cut of one-half point (50 basis points, in the jargon of the trade).
Share prices soared and investors' hearts leaped, at least temporarily. But many observers were more worried than relieved. Did Greenspan panic? And does the Fed chairman know something we don't? Is that knowledge so terrible that he dare not share it with us? The short answers are no, yes, and probably not.
Let's start with panic. Anyone who knows Greenspan, and has watched his handling of financial crises, knows that he is not given to panic. He prefers to amass a huge amount of information, analyse it dispassionately, and react - if any reaction is indicated - in a measured way to the problem. Panic is simply not his thing.
As for whether he knows something that those of us not in daily contact with the leaders of America's companies do not know, the answer is certainly "yes". And this is a good thing, given his responsibility for monetary policy.
But it does not follow that this knowledge is of some terrible impending event. No massive bank failures are on the horizon; the decline in unemployment claims filings last week suggests that the labour market, although softening, is not headed for meltdown; and consumers seem calm, at least so far, in the face of large debts and a decline in their wealth. As the Fed pointed out in the press release announcing its rate cut, "a significant reduction in excess inventories seems well advanced. Consumption and housing expenditures have held up reasonably well."
And although productivity may have weakened in the first quarter, "the impressive underlying rate of increase that developed in recent years appears to be largely intact".
That reassurance not only fails to calm the worriers, it actually increases their nervousness. As James Haskel, a Goldman Sachs vice-president, put it to me: "Why would the Fed cut rates inter-meeting when the inventory numbers are actually looking better? I think they are more worried about the consumer than they let on."
If Haskel is right, the Fed is very worried but is playing down that concern. In the announcement accompanying its rate cut the Fed merely referred to "the possible effects of earlier reductions in equity wealth on consumption", not the certain effects that many economists are predicting will be reflected in consumption before long.
Greenspan's reluctance to rely on a negative wealth effect as a basis for reducing interest rates probably reflects his uncertainty that such an effect will make itself felt with sufficient force to have a big impact on the economy. After all, investors have not exactly experienced a wealth wipeout. Bianco Research, the investment adviser, reckons investors put about $1,450 billion into mutual funds between October 1990 and March this year. That investment is now worth about $1,850 billion.
So unrealised profits now stand at some $400 billion. True, that is down from $750 billion, but it is not exactly a cause for hand wringing. So long as employment prospects remain reasonably good, and real incomes keep rising, consumers will continue to spend, although perhaps putting a bit aside in case a sharp downturn develops. Such a gradual increase in the savings rate is the stuff of a soft landing.
More to the point is whether the rate cuts will revive the economy. This is not certain, because the medicine might not fit the disease. Greenspan lists among his worries "slower growth abroad". But Japan's problems cannot be solved by a cut in American interest rates. Indeed, if that rate reduction weakens the dollar, making imports more expensive, it might actually exacerbate Japan's problems. As for euroland, no interest-rate adjustment in America can persuade the Europeans to resume the road to reform that they abandoned in Stockholm, when the French prepared for elections by promising to make it more difficult for employers to lay off redundant staff, and Brussels began to move against Germany's tax cuts, claiming they constituted "unfair competition".
Greenspan worries, too, about "the persistent erosion in current and expected profitability". His rate reduction should make it a bit cheaper for some companies to carry their swollen inventories, and perhaps add something to sales by making it less costly for consumers to borrow and to carry mortgage and other debt. But the bad profits news is coming from the high-tech and telecoms sectors, where massive excess capacity and sky-high inventories are likely to prove more of a deterrent to capital investment than can be offset by a half-point lowering of rates. Cutting interest rates to stimulate investment when demand is weak and capacity excessive, John Maynard Keynes once pointed out, is like pushing on a string.
Some of Greenspan's critics are saying he has not gone far enough, and that another cut of half a point is in order, or perhaps two. But core inflation is running at close to 3%, meaning that real interest rates are now below 2%. For the Fed to push them much lower, it will have to be convinced that the unprecedently rapid cuts it has already made are not putting the economy back on a growth path.
Meanwhile, the Fed policymakers are not alone in hoping that Congress will give the president the tax cut that will put some spending money into consumers' pockets.
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