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The Honolulu Advertiser
Posted on: Wednesday, March 21, 2001

Rate cuts by Fed 'not instantaneous'

 •  Fed created slowdown to stem 'irrational exuberance'

USA Today

With the stock market near meltdown and the economy in a strange twilight zone that might or might not be the early stages of a recession, the Federal Reserve moved aggressively again yesterday to reverse a slowdown that its own rate increases played a major role in creating.

Traders worked on the floor of the New York Stock Exchange minutes before the closing bell yesterday as investors disappointed by the Federal Reserve's latest interest rate cut vented their anger on Wall Street again.

Associated Press

But as the markets demonstrated by nose-diving abruptly after the Fed announcement, rate cuts aren't going to make anything dramatically better anytime soon.

"This stuff is not instantaneous," said Ken Goldstein, an economist with the Conference Board. "This is not, 'Take two aspirin, take an interest rate cut and wake up in the morning to a wonderful, beautiful new world.' "

Instead, economists say, the Fed's rate moves may not have a major impact until this fall, next winter or even later.

It's not for lack of effort. In just 2 1/2 months, Fed Chairman Alan Greenspan and his colleagues have unwound virtually all the interest rate increases they took a year to put in place, knocking 1.5 percentage points out of the 1.75 points they painstakingly added to overnight bank rates in 1999 and 2000.

Yesterday's half-point rate cut was the third since Jan. 3. Both the total amount of rate-cutting and the steps have been huge by modern Fed standards. The Greenspan Fed has preferred to nudge rates up or down in quarter-point baby steps, moving slowly so they don't do too much.

Though they ignored market clamor for an even bigger three-quarter-point cut yesterday, policymakers clearly are worried — and determined not to relive past mistakes. During the 1990-91 recession, it took the Fed seven months to cut rates as much as they have in less than three months this year.

Economists will forever blame that slow-starting, slow-motion rate-cutting in 1990-91 for helping to start and prolong the downturn.

Fed policy is dramatically different this time, even though the economy doesn't seem to be as wobbly now as it was then.

"Right now, we're on thin ice, but back then we were under water," said Rich Yamarone, director of economic research for Argus Research. "This is aggressive."

Economists disagree sharply over how bad things will get before they get better, but there's almost universal agreement that the Fed's uncharacteristically bold rate moves will make things better. Eventually.

Slow to show results

 •  At a glance

For the third time this year, the Federal Reserve slashed the federal funds rate by half a percentage point — to 5 percent — in an effort to stem the U.S. economy's downturn.

The rate cut failed to impress Wall Street, where many investors were hoping for a virtually unprecedented three-quarters of a percentage point cut.

Banks across the country responded quickly. In Hawai'i, First Hawaiian Bank, Bank of Hawaii and American Savings Bank cut their prime lending rate from 8.5 percent to 8 percent effective today. The prime rate influences rates on business loans as well as interest on credit cards and auto loans.

Mortgage rates have already fallen in anticipation of the Fed rate reduction, so they may not fall much further, analysts said.

The Fed left open the door for future rate cuts. Current conditions "suggest substantial risks that demand and production could remain soft," the Fed said in a statement. "In these circumstances ... the Federal Reserve will need to monitor developments closely."

Market analysts said the smaller-than-hoped-for rate cut could send stocks on another downward spiral this week. But they noted that stocks almost always rebound after the Fed cuts rates, though the process can take months.

Textbooks teach that Fed moves percolate through the economy slowly. It takes from six to nine months before their effect is fully felt. When it was trying to slow economy, the Fed last raised rates (by an aggressive half-point) in May 2000. Seven months later, in December, the economy hit a wall.

The lag is so long that it sometimes looks as if the Fed is having no effect at all. Long after the Fed began raising rates in June 1999, critics said the central bank had lost its power to slow the economy. They're not saying that anymore. Instead, shell-shocked investors are wondering whether the Fed has lost its power to speed things up.

"Whenever the economy slumps, two things always happen: People tend to forget about the lags between monetary policy action and how it affects the economy; and a lot of people say monetary policy has lost its power," said Mickey Levy, chief economist at Bank of America.

"Everybody always says this, and then it turns out that monetary policy does work with a lag, and monetary policy's just as powerful as it always was," Levy said.

If the Fed's rate cuts perform as they have in the past, the steady reduction in rates will eventually work throughout the economy to boost consumer and business borrowing. Businesses will find it easier and cheaper to raise money, and consumers will find lower rates for car loans, mortgages and even some credit cards.

A crucial but almost impossible-to-measure piece of what the Fed is doing is trying to reassure consumers — whose spending accounts for about two-thirds of the economy — that policymakers are on the job.

Greenspan has said repeatedly this year that consumer confidence is the economy's last firewall against a recession. Officials can only hope that their bold moves look good to wary shoppers.

"The Fed is probably the most important opinion-maker around," said Wayne Ayers, chief economist for FleetBoston Financial, who cites as proof the enormous media coverage of Tuesday's Fed meeting. "That's evidence that consumers pay attention to Greenspan."

"Many people pay attention to the Fed, maybe not directly to their announcements, but they hear about it in the news or in daily conversations," agrees Richard Curtin, who directs the monthly measurement of consumer sentiment for the University of Michigan.

Curtin said he thinks the Fed's rate cuts will help prop up confidence as the year unfolds. "It will come into view in the second half of the year as consumers begin to spend more," he said.

Psychological impact

Federal Reserve Chairman Alan Greenspan is trying to reassure consumers.

Associated Press

Ditto for investors — even though the Fed's action certainly didn't stop a major sell-off Tuesday. "There is a real psychological impact," said Mark Zandi, chief economist for Economy.com.

"If investors believe that the Fed is serious about circumventing recession, they may not buy stocks, but certainly they'll stop selling them, and that's the first step toward stabilizing business and consumer confidence."

Even with the Fed on the case, though, some economists worry that some of what is ailing the economy may be beyond the Fed's immediate ability to fix.

Bank of America's Levy notes that while the Fed's rate increases helped produce the slowdown, the economy also got hit by a spike in energy prices and a similar spike in the cost of business capital when the Nasdaq plunged. The Fed cannot directly fix either problem.

The economy has also been slowed by a sharp pullback in business investment after an orgy of high-tech investment left businesses with too much — from computers to fiber-optic networks. Zandi thinks the problem for information technology companies — and the ripple effect among financial services firms — is a serious problem.

"Another whole round of cuts and layoffs is coming, and I'm very concerned that consumer confidence isn't going to be able to withstand that," he said.

That's the dark view. But for every economist who thinks that the economy is either in or headed for a recession, there seem to be two or more who cite different data to paint a brighter picture.

A spring rebound?

Bank One chief economist Diane Swonk points to the turnaround in car sales, which stumbled late last year and caused automakers to cut production and lay off employees. But auto sales roared back in January and February, allowing automakers to burn off their overstuffed inventories and make plans to ramp up production this spring.

Swonk said the production increases will be "stunning," enough to put workers back on the job at auto plants and the thousands of companies that supply auto parts. That will help keep the unemployment rate from climbing to recession levels, which it has yet to do.

"Recessions are made of huge employment losses," said Swonk, noting that payrolls grew in January and February. "This just doesn't add up to that."

Still, the signs are maddeningly ambiguous. Consumer confidence has dropped by an amount that has always signaled a recession. On the other hand, confidence was so high when it began to drop that even now it's largely hanging in above recession levels.

"We've never had this big a drop in consumer confidence without a recession, but we've never had this high a level of consumer confidence with a recession," said David Wyss, chief economist for Standard & Poor's DRI.

So which indicator is right? Take your pick. The best Wyss and others can do is make an educated guess.

"Our guess right now is that (the Fed) will manage to prevent this from turning into an actual recession, but it's going to be a pretty hard landing," he said. "We're going to blow out a couple of tires, but we're going to walk away."

Nobody, not even Greenspan, is sure how this will turn out. Testifying before the Senate Budget Committee in January, Greenspan conceded there was a chance the economy might slip into "a recessionary environment" and added that "we won't know how this works out for a while."

In a little-noticed aside, he suggested that the uncertainty "is going to get resolved in about three months one way or the other."