Fed Move Won't Solve World Market Woes but Can't Hurt, Either

By Tom Petruno

Sept. 24, 1998 12 AM PT

A week ago he implied he wouldn’t. On Wednesday, however, Fed Chairman Alan Greenspan all but guaranteed the central bank will cut short-term interest rates when it meets Tuesday.

But while financial markets reacted with characteristic glee--what’s not to like about a Fed rate cut?--many Wall Street pros are dubious that the Fed’s anticipated move will take the stock market back into record territory soon.

Nor can a U.S. rate cut quickly fix what ails many of the world’s most troubled economies, from Asia to Russia to Latin America.

Still, it can’t hurt--and that’s what the surge in U.S. and Latin American stock prices said Wednesday.

Most important, Greenspan may be signaling that in the absence of meaningful action on the part of Western governments to restore confidence to a shaken global economy, the Fed sees the need to provide leadership.

“He made it clear [in Wednesday’s speech] that the reason they’re cutting rates is that the [global] economy is in trouble,” said Scott Grannis, economist at Western Asset Management in Pasadena.

But that also is what gives many investment pros pause when they consider how much of a rebound U.S. and foreign stock prices might enjoy, assuming the Fed indeed reduces its benchmark short-term nterest rate, the federal funds rate, from 5.5% now to 5.25% or 5% on Tuesday.

As Asia’s economic woes deepened in the first half of this year and then infected Russia, Canada, Latin America and other economies in the summer, the outlook for global growth has deteriorated sharply.

So, too, has the outlook for U.S. corporate profits. Boston-based First Call, which tracks Wall Street analysts’ earnings estimates, says analysts expect total earnings for major blue-chip U.S. companies to fall 0.2% this quarter from a year ago.

That may not sound like much, but any decline in profits usually is greeted with despair on Wall Street.

Thus, while the Dow industrial average--at 8,154.41 Wednesday--has surged 8.2% from its low of 7,539 on Aug. 31, it still is off 12.7% from its 1998 peak of 9,337.97.

That peak represented a market “priced for perfection” in the economy, many analysts argue. So to get back to that peak, investors would have to perceive that all of the bad news of recent months has been neutralized. That’s unlikely any time soon.

“The problems [facing the economy] are more pervasive than at any time in this business cycle” that began in 1991, says Tim Morris, investment chief at Bessemer Trust in New York.

Still, some analysts say expectations that the stock market’s rally will fade soon may be underestimating the psychological boost a Fed rate cut could give investors.

Charles Biderman, whose Trimtabs.com firm tracks mutual fund inflows, estimates that more than $5 billion in new money flowed into U.S. stock funds Monday and Tuesday, adding to the inflows of the last few weeks as the market has regained its footing.

News of a Fed rate cut may well make many investors more aggressive in betting on a market rebound, Biderman said.

Indeed, investors who have large cash reserves sitting in money market mutual funds may become more inclined to shift that cash elsewhere soon: Money fund yields--which have been stable at about 5% for nearly two years--should begin to slide if the Fed cuts its key rate by at least half a percentage point Tuesday and makes further cuts in the months ahead.

That would be the most direct tangible effect of a Fed cut: Short-term rates across the economy should decline as well.

Yields on short-term U.S. Treasury bills fell further Wednesday after Greenspan’s speech, even though yields on Treasuries of all maturities now are already well below the 5.5% fed funds rate.

Grannis expects that shorter-term Treasury yields will continue to lead the Fed. In other words, although the three-month T-bill rate, at 4.56% now, clearly anticipates a Fed cut, it could easily fall much lower if investors assume the Fed must slash the fed funds rate well below 5% in coming months.

Likewise, banks’ prime loan rate, now 8.5%, should fall in tandem with any Fed move. That would affect some consumer loan rates.

But whether lower short-term rates would encourage more companies and individuals to borrow and spend--providing the extra economic boost that a Fed cut would be intended to give--remains uncertain. One potential problem: Many U.S. banks have become more concerned about making loans, on worries that the economy could be headed for recession, threatening marginal borrowers.

What’s more, longer-term Treasury yields--and thus home mortgage rates--may not fall much more, Grannis says. Those yields, already down significantly, are more likely to stabilize as investors wait to see how sharply the Fed reduces short-term rates.

Worldwide, a Fed cut could stop the hemorrhaging of troubled economies, even if it’s no quick cure. Lower U.S. rates would take pressure off rates in many struggling economies, such as Brazil. Long-term bond yields in many emerging markets have already slid from recent peaks.

And lower U.S. rates also could weaken the dollar, reducing the currency-devaluation pressures that other countries still face.

In short, the Fed may incite a global “relief” rally. But its staying power would be suspect.

Tom Petruno can be reached by e-mail at tom.petruno@latimes.com.

* IN GREENSPAN’S WORDS: Fed chief, hinting at rate cut, paints troubled economic picture. A1

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Market Leads the Fed--and Banks

Shorter-term Treasury security yields have already fallen sharply, anticipating a cut in the Fed’s benchmark short-term interest rate, the federal funds rate. Banks’ prime lending rate, at 8.5%, should come down soon if the Fed cuts, analysts say. Meanwhile, stocks zoomed on hopes for lower rates.

THE RATE PICTURE

Bank prime rate: 8.5%

Fed funds rate: 5.5%

Treasury yields:

3-mo. 4.56%

1-yr. 4.38%

2-yr. 4.55%

5-yr. 4.47%

10-yr. 4.67%

30-yr. 5.17%

Source: Bloomberg News

HOW STOCKS FARED