Recession Fears Prompt Fed to Cut Rates Again
The Federal Reserve cut interest rates Tuesday for the seventh time this year, warning that the economy may continue to weaken and signaling its willingness to ease rates even more to ward off a recession.
The rate-setting panel headed by Fed Chairman Alan Greenspan said it would reduce its benchmark rate for overnight loans between banks from 3.75% to 3.5%, the lowest level in seven years. That so-called federal funds rate was 6.5% when the central bank began cutting in early January.
Although the quarter-point reduction had been widely anticipated, stock prices fell sharply after the Fed announcement. The Dow Jones industrial average plummeted 145 points to close at 10,174, and the Nasdaq index lost 50 points, finishing at 1,831.
Economists said the sell-off appeared to reflect investor disappointment that the slowdown has shown few signs so far of responding to the central bank’s best efforts to engineer a recovery.
“There is still a significant possibility of the economy sliding into a recession” said Sun Won Sohn, chief economist at Wells Fargo & Co. “Chairman Greenspan wants to take no chances.”
This year’s series of rapid-fire rate cuts represents the Fed’s most aggressive effort to stimulate the economy since the deep recession of the early 1980s. Although the current slump is considerably milder, so far it has not been revived by the tonic of lower interest rates.
In announcing Tuesday’s rate cut, the Fed noted that consumer spending has held up reasonably well during the slowdown. But it warned that business profits and capital spending continue to weaken and economic growth is slowing overseas. Although the U.S. economy’s long-term prospects remain favorable, it said, “the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.”
The Fed action should prompt similar reductions in rates charged on auto loans, home equity loans and credit lines, variable-rate credit cards and business loans pegged to the benchmark prime rate. The impact on new fixed-rate mortgages is expected to be negligible because they are influenced mainly by long-term bond rates. Savers will be penalized somewhat as the Fed cut is mirrored in rates paid on savings accounts and certificates of deposit.
Major banks quickly matched the Fed rate cut Tuesday, trimming their prime lending rate to 6.5% from 6.75%.
Economists said the Fed’s rate rollbacks this year--five half-point reductions followed by two quarter-point cuts--should begin producing results later in the year. It typically takes six months or more for lower borrowing costs to boost business investment and consumer spending.
The beneficial effect of the rate cuts is expected to be reinforced by two other economic windfalls: $38 billion in tax-rebate checks that are being mailed to millions of Americans and recent declines in the price of gasoline, natural gas and other fossil fuels.
Martin Regalia, chief economist for the U.S. Chamber of Commerce, said the combination of interest rate cuts and tax rebates of up to $600 per household represents “a very, very stimulative policy.”
Yet in the Fed’s view, the risk of recession still outweighs the possibility that interest rate cuts will rekindle inflation, analysts said. The wording of its announcement suggested it is prepared to cut rates again if the economy fails to improve.
“They were pretty clear that they’re leaving the door wide open to do another [quarter-point cut] if they see fit,” said James Paulsen, chief investment officer with Wells Capital Management.
The current slump has not been classified as a recession because economic growth has only slowed, not stopped. But the growth rate fell to an anemic 0.7% in the second quarter, and some analysts are predicting it may soon enter negative territory.
Unlike most downturns, which typically begin when consumers turn cautious and stop spending, the current slowdown is attributable largely to cutbacks by businesses that over-invested in new equipment and overstocked their inventories during the technology-driven boom of the late 1990s.
As a result, it may be less responsive to interest rate cuts orchestrated by the Fed, some economists said.
“This business cycle is quite different,” said William C. Dudley, chief domestic economist for Goldman Sachs. “This is an investment boom-bust cycle where the Fed isn’t playing as important a role in either direction.”
Recent statistical reports have sent mixed signals about the state of the economy.
Unemployment has climbed to 4.5% from a low of 3.9% last fall, and manufacturers have eliminated 857,000 jobs over the last year. Industrial production has fallen for 10 consecutive months, business investment has dropped sharply, and corporate profits continue to shrink. U.S. exports and imports are declining in tandem as other countries grapple with their own slowdowns.
At the same time, housing construction and home sales have boomed in response to low mortgage interest rates. Consumer spending has remained surprisingly strong, and new claims for unemployment benefits have tapered off in recent weeks. The pace of inventory reductions is beginning to moderate, suggesting businesses may begin restocking their shelves, stimulating new production.
On Monday, the Conference Board said its index of leading economic indicators rose for a fourth consecutive month, signaling that the economy may begin to recover by the end of the year.
“The economy is beginning to show signs of stabilizing,” said Mickey D. Levy, chief economist for Banc of America Securities. “The worst of the slump is behind us.”
Levy said he expects to see clear signs of recovery by the fourth quarter. Some economists believe an upturn could come even sooner.
“This signals that the Fed is beginning to sense that an economic recovery is beginning,” said First Union Corp. economist Mark P. Vitner. “I think there’s a good chance that this could be the last interest rate cut this year.”
So far, there is little evidence that Fed rate cuts will spark an inflationary spending spree. The consumer price index declined in July, largely in response to falling energy prices. The core inflation rate, which excludes volatile food and energy prices, is a relatively low 2.7%.
In the 1990-91 recession, the Fed reduced the real, or inflation-adjusted rate on overnight loans all the way to zero to trigger a recovery. After Tuesday’s reduction, the real federal funds rate will be about 0.8%. Economists said that leaves room for additional rate cuts if the economy fails to perk up in coming weeks.
Several analysts said they think stock traders were hoping the Fed would cite evidence of a recovery in progress, and overreacted to the cautionary tone of the rate cut announcement.
“I think what the stock market is adjusting to is the prospect of a more protracted slowdown, and a very modest recovery,” Vitner said. “They’re scaling back their expectations.”
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Reaction to Fed Cuts
The Dow Jones industrial average is below where it was when the Fed began cutting rates Jan. 3--a sign the market doesn’t believe an economic recovery is near.
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12/29 close: 10,786
Tuesday’s close: 10,174
Source: Bloomberg News
