Hijacked from the Bubble thread:
After the Fed Cuts Rates -- Then What?
By Maggie Mahar
(Maggie Mahar is a columnist for Bloomberg News. The
opinions expressed are her own and don't represent the judgment
of Bloomberg LP or Bloomberg News.)
New York, Sept. 29 (Bloomberg) -- Today, Alan Greenspan
is scheduled to save the world.
The pressure on the Federal Reserve Chairman is immense. If
he fails to announce a much-awaited interest rate cut, the shock
would rock stock markets 'round the globe. Most observers are
convinced that he will deliver, but questions remain:
Will it be a cut of 25 basis points? Fifty basis points?
Will this be is the first in a series of cuts?
Leaving aside questions of whether he will or he won't --
and by how much -- there's one question I can't help but ask:
''What good will it do?''
The problem facing Western markets isn't that interest rates
are too high, but that prices and profits are too low. Stock
markets in Europe and the U.S. have been plummeting on earnings
reports. Would lower rates boost earnings?
''Absolutely not,'' says Ken Goldstein, at the New York-
based Conference Board. ''We've already had the monetary stimulus
of low rates -- we've seen the long bond approaching 5 percent.
And, with the cost of commodities sliding, we've had the fiscal
stimulus of lower prices.''
Turmoil
If anything, a U.S. interest rate cut could add to the
turmoil at home and abroad.
In theory, if the Fed cut rates, both consumers and
companies would borrow more and spend more -- stimulating the
economy.
U.S. consumers are already spending freely -- personal
spending rose by 0.6 percent in August alone while personal
income jumped 0.5 percent. Meanwhile, the savings rate is at an
historic low -- under 1 percent. How much more could consumers
spend?
The problem for manufacturers in both the U.S. and Europe
isn't that shoppers are buying less, but that they're paying
lower prices -- and buying more foreign goods.
And the price of those foreign goods -- mainly Asian --
continues to drop.
''Import prices for August were down 6.4 percent over August
'97 -- up from a 5.6 percent decline in July,'' says David Orr,
chief economist at First Union's Capital Markets Group.
Meanwhile, imports from Asia last month climbed 12.8 percent
year-on-year in terms of volume, Orr points out. By the same measure, imports from Japan are up 6.3 percent.
Inflation
That's one reason earnings aren't growing at the double-
digit rates needed to sustain stock prices. But the fact is, says
Orr, you can't expect to have both low inflation and double-digit
profit growth:
''If you manage to maintain the good news on the inflation
front, you pay for it with lower profit margins. In the real
world, you can have 1 1/2 percent inflation, but profit margins
fall. The market has been pricing stocks as if you could have
both -- and that's just not tenable.''
''The stock market could easily go down by another 10
percent,'' Orr predicts ''I wouldn't be surprised if it dropped
by 25 percent.''
But that's precisely why we need interest rate cuts, say
the advocates. As share prices slide consumers will feel poorer -
- and spend less. (Who knows, they might even save.)
Charge It!
Yet it's not clear how the Fed could fill shopping malls.
An interest rate cut is not like a tax cut - it doesn't put money
in citizens' pockets; it just makes it easier to use credit
cards. (At best, those who refinance their mortgages would wind
up with extra cash, but in most cases, the transaction costs of
refinancing a $100,000 mortgage will eat up the first year's
savings.)
But wouldn't lower rates spark the housing market by making
mortgages more affordable? ''With mortgage rates already
anticipating a Fed ease, there's no reason to expect that an
actual ease would change the housing picture,'' saysOrr.
Indeed, he points out, housing is already booming: ''Economists
talked about the housing market 'slowing' only because 'August
was 5.5 percent below the virtually unheard of level of 1.71
million in July. In fact August housing starts of 1.51 million
were, by any reading of historical data, very high.
''Going forward, even if starts stay close to these 'boom'
levels, they will not contribute to GDP growth,'' he adds.
The commercial real estate market also appears to be
peaking. Is that because developers can't borrow enough to build
more?
Not according to the Office of the Comptroller of the
Currency. Earlier this month, the OCC warned terms for real
estate loans are already getting too loose. Of the banks it
surveyed, it found 43 percent had relaxed standards for real
estate loans, while only six percent had tightened. The OCC also
cautioned that the level of risk on credit card and other types
of consumer loans has climbed to perilous heights.
Indeed, inthe U.S. easy money may be part of the problem,
not the solution.
Hold the Espresso
In theory, lower rates will allow U.S. companies to borrow
more and expand their business, but there's little evidence that
what's crimping profits is a lack of investment capital. To the
contrary, signs of over-capacity in industries ranging from
chemical and steel to autos and micro-processor are mounting. As
for smaller businesses, bankers have been generous to a fault
suggested the OCC, naming ''loans to mid-sized businesses'' as an
area where standards have loosened.
We just don't need more micro-chip factories -- or more
coffee bars.
Where liquidity is needed, of course, is in emerging
markets. But the credit crunch there was created by the market,
not central bankers. And even a 50 basis point cut won't send
either lenders or investors rushing to pour money into Indonesia,
Korea or Brazil. If Treasuries pay less, investors might consider
taking a risk on corporate debt -but the opportunity to make
another 1/2 percent won't persuade risk-adverse portfolio
managers to buy bonds in Brazil
Nor would a U.S. rate cut lighten the burden significantly
for Asian countries carrying dollar-denominated foreign debt.
Again, the problem is not that the interest rate on the debt is
too steep -- but that they're trying to repay in devalued
currencies.
Granted, if a rate cut were big enough, it might push the
dollar low enough to make a difference. But a weak dollar would
create other problems for exporters in Japan, Brazil -- and even
in Europe. Suddenly, their exports would no longer be as cheap.
Psych Out
By far the strongest argument for Fed action is
psychological -- a rate cut could boost the confidence of markets
worldwide. But trying to fine-tune the markets' moods is a tricky
business. (Playing with people's heads is always dangerous.)
Tomorrow, for example, I suspect that Greenspan will
announce a cut of just 1/4 percent -- and markets will be
bitterly disappointed. Trouble is, share prices have already
moved up on the expectation of Fed action. If Greenspan promises
less than 50 basis points, my guess is that ungrateful markets
will tumble.
And by trying to do more, the Fed might only stir up the
pot, creating more uncertainty at a time when the financial world
is already in flux. For it's impossible to predict what effect a
'98 rate cut would have six months done the road -- when any real
impact would be felt.
That's why Euro bankers refuse to consider the idea. The
debut of the Euro is their first concern - they can't afford any
more uncertainty. (Nor can the world.)
Managing the Bubble
The problem in the end is the Fed has put itself in a
position where it's expected to manage the world economy. ''and
now it's in the business of bubble management,'' says Jim Grant,
editor of Grant's Interest Rate Observer.
''Risk has been over-priced, credit has become ever more
abundant and cheaper. A Fed funds rate of 3 percent was the
starting pistol,'' says Grant. ''And as long as the Fed funds
rate was set low, it was an effective narcotic.''
''Now the Fed is appalled at what it helped to create --
excess speculation -- and it's supposed to help the real economy
without re-igniting the boom. ''
Try to imagine a bubble collapsing in an orderly fashion.
It's hardly surprising that Greenspan feels he has to make a
heroic attempt. ''He wouldn't be human if he didn't have a
messiah complex by now,'' Grant observes. But as he sees it the
chairman has only one out: ''I'm not sure what I would do if I
were chairman, -- except resign.''
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