Rate Cut, Yes; Huge Tax Cut, No

The Federal Reserve’s half-point interest rate reduction will take months to filter through the economy. But its immediate effect was dramatic. Stock exchanges posted sharp gains, and President-elect George W. Bush quickly provided his own spin, saying the rate action bolsters his case for a large across-the-board tax cut. Bush remains wrong. The early response to the decrease demonstrates that the monetary policy that helped to control the economy on the way up may work as well when it is contracting.

Both the size and the surprise timing of the cut sent a clear signal that the central bank takes the declining economic indicators seriously. The last time the Fed cut rates by half a point was nine years ago, just as the economy was emerging from a slump. A decrease between scheduled meetings of the Fed’s Open Market Committee last occurred in the fall of 1998, when financial crises in Asia and Russia sent panic through the financial markets.

This time, the Fed is reacting to reports that the economy is slowing much faster than anticipated. Particularly significant was the sharp decline in an index that measures manufacturing orders and output; the National Assn. of Purchasing Management’s measurement declined in December to its 1991 level. The rising cost of energy, which hit California particularly hard, also worries the Fed because it is a drag on both consumers’ buying power and business profits.

Since his election as president, Bush has been warning about a recession, in part to build a case for his $1.3-trillion tax cut. He declared Wednesday that the interest rate cut is “not enough to serve as a stimulus to encourage capital formation, economic growth, job creation.” The Fed itself acknowledged that the decrease might not go far enough and said it may reduce rates further.

Even economists who believe that the Fed under Alan Greenspan’s chairmanship has no magical powers believe that tax cuts take too long to produce the desired effect--and when they do kick in may overheat an already recovering economy. Even so, Democrats in Congress are easing their opposition to substantial cuts, though the figures they might accept remain short of Bush’s $1.3 trillion. Legislators should be wary of the tax-cut bandwagon.

Financial markets, businesses and consumers built much of their confidence during President Clinton’s years on the base of the government’s spending restraint and the Fed’s fine-tuning of interest rates. This helped create a decade of unprecedented growth.

There is no need to change that formula, yet. The Fed has been monitoring the pulse of the economy more closely than anyone else and reacted decisively to the signs of a precipitous slowdown. A big, broad-based tax cut on top of that isn’t needed.