Don't place a bet on the Fed's help
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Will the Fed save the Dow?
The foregoing is consistent with the hypothesis that economic questions of significance can be represented monosyllabically. But more to the point, it's what countless investors wondered this wretched week, as they watched their net worth do what their waistlines will not.
Many have taken comfort that the current carnage (down 369 points so far this week, and it ain't over yet) might at least soften the heart of the nation's chief banker, Federal Reserve Chairman Alan Greenspan, prompting him to cut the short-term interest rate known as "Fed funds."
This, if you've been wondering, is the gauge that banks use to set their prime lending rates, which determine how much consumers and small businesses pay for credit-card debt, home-equity loans and lots of other important borrowing.
Moving this rate up or down has a powerful effect on the economy, making credit either harder or easier to obtain. This was demonstrated most dramatically in 1980, when the then-Fed chairman, Paul Volcker, hiked rates way up around 17 percent. Volcker was trying to whip inflation, and it worked -- by throwing the nation into a painful recession.
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Changing conditions
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Similarly, in 1992, Greenspan and his colleagues on the Fed's Open Market Committee were trying to reverse the effects of the gulf war recession and the savings-and-loan crisis. They dropped the Fed funds rate to 3 percent, its lowest level since 1963. This pumped credit into the economy and strengthened banks' balance sheets, setting the stage for the much stronger growth of the last few years.
The Fed funds rate has been at 5.5 percent for the last 18 months, but in that time the world has changed dramatically. Asian currencies and markets have tanked, global growth has slowed dramatically, and the stunning U.S. economy looks ready to slow down.
All of this is reflected in the rates for longer-term U.S. Treasury debt, which, unlike the Fed funds, are set by investors in the open market. Thirty-year U.S. Treasury bonds, for instance, now yield a record low 5.30 percent, which is below the Fed funds rate. This is slightly unnatural -- just as with home mortgages, rates usually go up with the length of the loan -- and some analysts see it pressuring the Fed to drop its rate back into line.
That would cheer the stock market, because cheaper money would both help companies cut costs and give consumers more to spend. A Fed funds cut could also help troubled nations in Asia and Latin America, by making it slightly less attractive for investors around the world to shelter their capital in U.S. dollars. That might mean less money fleeing shaky markets in Hong Kong or Buenos Aires.
So why not ease, already?
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Danger of cheap credit
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It may be, as some analysts contend, that the Fed doesn't think the economy is weak enough yet. The unemployment rate remains below 5 percent, consumer spending and confidence remain quite high, and corporate profits, though shrinking, are still relatively robust.
Moreover, argues economist Mark Zandi, of Regional Financial Associates, the Fed is fearful of rerunning the late 1980s. When the market had its big crash in 1987, the central bank rushed to the rescue, lowering rates quickly and restoring investor confidence so that the Dow still finished that year with a gain.
Cheaper credit, however, threw the economy into overdrive the next year. Real-estate investment, which was already inflated, became a bubble. When it burst in 1989 (as the Fed pulled interest rates back up), hundreds of banks collapsed and the whole country fell into recession.
The Fed, Zandi contends, "doesn't want to be the lender of last resort for the global economy." While the pressure may build enough to force their hand, it's at best a 50-50 bet that Greenspan & Co. will ride to the market's rescue before the end of this year, he says.
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