Capitalizing on Consumer Caution : Economy: The Fed should resist the urge to lower interest rates until households are ready to start spending again.
As signs of a sustainable U.S. recovery begin to melt away under the glare of weak employment statistics and weaker retail-sales statistics, all eyes including those of President Bush have turned to the Federal Reserve as the best hope to rescue the recovery by lowering interest rates. The Fed has already begun another round of interest-rate cuts. Unfortunately, however, there is likely to be little immediate impact on economic growth.
The reason for the Fed’s inability to stimulate either money growth or the economy lies with a simple reality: The process of credit creation is stalled. Lenders to the household sector (commercial banks) do not want to lend and most households don’t want to borrow.
Bank lending has been stalled by the need of most banks to rebuild the quality of balance sheets after heavy losses on real-estate loans. Why should the banks make risky loans when the Fed policy of pushing down short-term interest rates has provided them with guaranteed risk-free spreads of more than a juicy full-percentage point for holding two- and three-year government securities. Beyond that, banks are earning 18% or 19% on credit-card balances.
Households are reluctant to borrow because they are engaged in rebuilding the quality of their own balance sheets by paying down debt. Debt-to-income ratios are unusually high for the recession phase of the business cycle, and most households, uncertain about the economic future and dismayed by the loss of value of their major asset, the house, have begun to pay down debt. Until the process of debt pay-down by households is complete, lower interest rates provided by the Fed will result largely in mortgage refinancing that includes mortgage pay-downs instead of increased borrowing and more spending as was the case during the 1980s.
Until the process of balance-sheet repair by households is complete, the Fed could probably cut interest rates to 1% or below without much positive impact on spending. The only effect would be to bring forward the time when consumer debt burdens are once again low enough to allow resumption of normal spending patterns.
The repair of bank- and household-balance sheets is a healthy process. While delaying recovery for now, it means that when balance-sheet repairs are completed, the presence of low interest rates is likely to result in a sharp surge in consumer spending and a stronger than expected recovery, probably sometime during the first half of next year.
How the Fed reacts to this will determine the path of interest rates, exchange rates and stock prices. If the Fed keeps interest rates at current levels, while the economy continues to weaken, the result will be a stable dollar and a bond rally that pushes yields on long-term bonds to or below 7%. If, alternatively, the Fed panics and pushes interest rates down another percent or percent-and-a-half, the result will be a weaker dollar and bond-market yields that do not fall below 7.5%.
A “hold-steady” policy, as the economy continues to weaken, will probably result in an unusual circumstance in which after three or four discount-rate cuts, stock prices actually fall. That has only occurred once in the Fed’s history since 1914, during the ominous period from 1929 to 1931. The implication of weaker stock prices in the early ‘90s after successive discount-rate cuts would not be that a depression is imminent, but rather that a healthy correction of balance sheets is under way. The Fed, therefore, should not be overly frightened by the inevitable analogies to the Great Depression and seize the opportunity to make real progress against inflation.
If the Fed does panic and begins to push interest rates down rapidly, the result will be a weaker dollar and a limit to the drop in interest rates. Stocks will probably be stronger in the near term but will reverse course when the Fed is forced to push interest rates back up in the face of a weaker dollar.
The Fed faces a historic choice this fall. If it keeps interest rates close to current levels while waiting for household- and bank-balance sheets to adjust, it will seize an important opportunity to bring inflation and interest rates down to the levels prevailing in the early ‘60s, before Lyndon B. Johnson’s “guns and butter” folly kicked off two decades of inflation. If, on the other hand, the Fed panics and acts to support the stock market by pushing interest rates lower, the result will be an upturn in interest rates by year’s end and continued complaints about “stubborn” U.S. inflation.
