Cut Suggests Fed Meant to Lift Market
For months, Federal Reserve Chairman Alan Greenspan has gone out of his way to show that he is not trying to rescue the stock market.
When the market and the economy tanked in December, Greenspan refused to cut interest rates to revive them, offering only a statement that the central bank might consider cuts if conditions worsened. When beleaguered investors clamored for a three-quarter-point rate cut in March to stop a further plunge, he gave them only a half-point.
But try as he might to claim otherwise, Greenspan’s actions suggest he is indeed focused on bailing out the market, and for good reason: It’s just about the only thing the Fed can immediately influence to help lift the economy out of its slump.
“Increasingly, the stock market is the primary transmission mechanism” for Fed rate cuts, said Robert Z. Lawrence, a Harvard economist and former Clinton administration economic advisor.
Greenspan’s trouble in giving Fed policies teeth illustrates how much the economy has changed in recent years and how uncertain central bank policymakers are about what they should do next.
“If he were to speak from his heart,” veteran Fed-watcher David M. Jones said of Greenspan, “he’d tell you he doesn’t know where we’re headed. He has to be worried this is a situation that’s slipping away from him.”
The Fed’s latest action--Wednesday’s half-point cut in the federal funds interest rate banks charge each other for short-term loans--contained all the push and pull of the central bank’s convoluted dalliance with the market.
Coming after investors had given up on quick Fed action and at a time when stocks were rallying on their own, the reduction seemed crafted to show that the central bank was unconcerned about the market. But the surprise of the move suggested the very opposite aim: to rivet investors’ and executives’ attention and convince them that the Fed would make everything better again.
“What the Fed is saying is, ‘Look, go ahead and spend, because we’ll do whatever it takes to make sure there’s no recession,’ ” said Sung Won Sohn, chief economist with Wells Fargo & Co. in Minneapolis.
But making good on that pledge is proving considerably more complicated than almost anybody expected. That’s largely because what needs repair in the economy and what the Fed has in its tool kit aren’t always compatible anymore.
Until recently, the central bank’s biggest job was managing consumer demand, which it did by raising or lowering interest rates to directly affect how many cars, houses and washing machines people bought. Its biggest worries were either too much demand, which causes inflation, or too little, which leaves companies with unwanted inventories and can lead to recessions.
But in a statement accompanying Wednesday’s rate cut, the Fed effectively said that demand is not the problem. “A significant reduction in excess inventories seems well advanced,” the central bank said. “Consumption and housing expenditures have held up reasonably well.”
So what is the problem?
According to economists, it is first and foremost one of supply rather than demand. For that reason alone, it is more difficult for the Fed to deal with.
After the wild years of the late 1990s, corporate America has so expanded its capacity to churn out goods and services that it has wildly outstripped demand for its products.
As a result, many industries have capacity to burn. The telecommunications industry, for example, is using a microscopic 2.5% of its vast new fiber-optic network, according to a recent estimate by Merrill Lynch & Co.
That means companies are unlikely to borrow in order to add still more capacity, no matter how low the Fed pushes interest rates.
“Rate cuts are not going to get more investment. This route for influencing the economy is clogged,” said Robert E. Litan, economic studies director at the Brookings Institution in Washington. Unfortunately, so are two others on which the Fed traditionally has relied.
Consumers might be expected to take advantage of lower rates to buy still more. But they already borrowed and bought with abandon during the last decade.
And lower rates might be expected to make dollar-denominated investments less attractive and thus push down the dollar’s value, making U.S. exports cheaper in international markets. But the dollar has stayed strong overall.
In such circumstances, the Fed is forced to rely on the one tool that still seems available: the stock market.
“What the Fed is doing,” Litan said, “is trying to keep a floor under the stock market” to ensure that paper losses don’t discourage consumers from buying and to convince executives they needn’t slash payrolls. “The Fed is in a race to restore confidence,” he said, and it believes a market revival is the most immediate means to achieve that.
The central bank’s embrace of the market has to be a painful choice for policymakers. After all, stocks’ wild rise in the late 1990s caused many of the problems the Fed now must cope with. And the central bank’s focus on the market is attracting sharp criticism from some influential quarters.
“If I told you unemployment was 4.2% and inflation was 3%, would you think the economy was in trouble?” asked Nobel laureate Milton Friedman, one of the most influential economists of the era. “But we’re treating this as if it’s a full-blown recession. The Fed is overreacting.”
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RALLY CONTINUES
Stocks rose again, led by Nasdaq’s 4.9% surge. C1
