Plunging interest rates alarm critics
ANALYSIS: SOME WARN CUTS JUST DELAY INFLATION, SLOW GROWTH, LOWER DOLLAR
By David A. Sylvester
Mercury News
Posted on Mon, Jun. 30, 2003
After cutting interest rates to a half-century low last week, the sacrosanct Federal Reserve Board is now facing unusual controversy: Are rates too low?
A growing number of economists are asking if Fed Chairman Alan Greenspan went too far in trying to stimulate economic growth.
The fear is that ultra-low interest rates may encourage consumers and businesses to take on debt that will prove difficult to repay when rates rise. Low rates may seem a temporary godsend for homeowners who want to refinance their existing mortgages and pay less each month, but some say Greenspan and the Fed governors are postponing unpleasant consequences: higher inflation, slower long-term growth and a sharply lower dollar.
``They are moving us completely in the wrong direction,'' says Edward Leamer, director of the UCLA Anderson Forecast in Los Angeles. ``They're setting the stage for the next economic problem of stagflation with higher inflation and sluggish growth.''
Instead, some say the economy, particularly in Silicon Valley, must face an even stronger dose of free-market capitalism: A shake-out that weeds out weak, money-losing companies so the survivors can become stronger and more profitable.
The legacy of the late 1990s Internet bubble was that soaring stock prices made it easy for companies to expand and venture capitalists to finance too many start-ups. The subsequent bust has been more of a ``business recession,'' hitting corporations and profits much harder than consumers -- but it hasn't gone far enough to offset the excesses.
``What the Fed is trying to get is the upside of the cycle without the downside,'' says Barry Ritholtz, chief market strategist for Maxim Group.
Others are harsher in their assessment. ``I've never seen a central bank so abuse its powers,'' says Michael Belkin, longtime Fed critic and independent financial adviser.
Silicon Valley lies at the epicenter of the boom and bust -- and interest rate cuts have done little to help the tech industries. During the first quarter of this year, 65 of 150 of the largest public companies here, or 43 percent, lost money, according to Mercury News business research.
That's an improvement from the 72 firms, or 48 percent of the SV150, that lost money a year ago -- still high after almost three years of decline.
Business conditions appear to be improving at a slow and painful rate for the biggest technology companies. Total sales among the SV150, without counting Hewlett-Packard's extra sales from its merger with Compaq, declined in the range of 5 percent in this first quarter compared with a year ago.
Overall profits were $1.3 billion compared with a loss of $4.3 billion a year ago. However, that profit margin is slightly more than 2 percent of sales -- one-third of the average 6.1 percent margin from 1985 to 2000.
Unless profits improve dramatically, the valley is expected to undergo more business failures and mergers. This month, Palm's purchase of rival Handspring and Oracle's hostile bid to take over competitor PeopleSoft are examples of what could follow.
Those who defend Greenspan and the Fed say the nation's central bank has fought to stave off what could have turned into a much worse recession. They point to the 13-year slump in Japan, which is the world's second-largest national economy. Last year, Fed economists examined Japan and concluded that its central bank failed to cut rates quickly enough to invigorate the economy. The Fed also arrived at another telling conclusion: It is better to make the mistake of overstimulating the economy than to risk deflation.
However, many economists believe inflation, not deflation, is the bigger danger. Former Fed Chairman Paul Volcker was quoted last week saying he saw ``no prospect of real deflation like we had in the U.S. and other countries in the 1930s.''
Sung Won Sohn, chief economist at Wells Fargo Bank, believes the Consumer Price Index (CPI) actually masks hidden inflation in items such as medical costs and insurance because the index is overly influenced by plunging rents and low mortgage rates. If the figures used to calculate rental costs are taken out, the CPI is actually running at 2.7 percent a year, he says.
Combine that with the current low interest rates and the economy now is operating on the greatest ``negative'' real interest rate since 1980. In effect, anyone holding on to cash will lose money: Inflation is going to eat away at the value of cash faster than it gains from earning interest.
``When real interest rates are negative, it provides a tremendous incentive for people and businesses to borrow, which in turn invariably leads to more spending, thus an increase in economic activity,'' wrote Irwin Kellner, an economist who studied Fed policy for regional forecasting firm Economy.com last week.
So what's wrong with this?
For one thing, negative interest rates tempt unsophisticated investors to violate prudent investment guidelines and transfer money from safe, short-term investments to more speculative investments with higher yields, such as junk bonds.
If the economy sours, risky investments are hardest hit.
Fed critics also argue that low interest rates are medicine for the wrong illness. Consumers buy more cars and homes, but major corporations won't install new equipment and build plants -- not when the real problem is overcapacity.
It may take years to know if the Fed critics are right. The brakes and gas pedal of monetary policy work notoriously in fits and starts. But that doesn't calm the nerves of the onlookers watching Greenspan's aggressive intervention in financial markets.
``He's playing a really dangerous game,'' says Joe Corona, head trader for the legendary options firm run by Anthony Saliba in Chicago.
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