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The Honolulu Advertiser

Posted on: Sunday, November 11, 2001

Experts worry about downside to low rates

By Mike Hudson
Detroit News

DETROIT — The Federal Reserve's resolute move last week to cut short-term lending rates another half point to 2 percent has some economy watchers asking whether rates are being slashed too deeply — a question that was inconceivable just a few months ago.

Nine previous cuts this year have brought no measurable improvement in business conditions, including corporate and consumer confidence. Under ordinary circumstances, analysts would be looking for signs of progress nine months after the initial cut, but the Sept. 11 terrorist strikes checked any momentum the economy was building.

Now, economists are beginning to worry about the downside of rock-bottom rates, including higher inflation, a possible credit crunch and an empty monetary-policy quiver for the Fed in the months to come.

"Heightened uncertainty and concerns about a deterioration in business conditions both here and abroad are damping economic activity," the Fed said in a prepared statement. "The risks are weighted mainly toward conditions that may generate economic weakness."

But Tuesday's cut, some economists said, really was motivated by an urge to appease a jittery stock market, which has come to rely on periodic cuts to buoy investor sentiment — rather than sound long-term monetary policy. Another crash in the stock market would further erode consumers' paper wealth and perhaps lead to curbed holiday spending — a detrimental proposition in a season already shaping up to be the worst in a decade.

"They are running out of ammunition, but they really didn't have a choice on this one," said Sung Won Sohn, chief economist for Wells Fargo Bank in Minnesota. "The stock market expected a half point and we can't afford to see a drop on Wall Street. But there will be pitfalls in the future like inflation and an effectively impotent Federal Reserve."

Some analysts said attention should be turned away from monetary policy tweaking and toward a substantive congressional stimulus package, which would include increased unemployment benefits, additional government spending and tax cuts.

Proponents of the rate cuts say there's a need for action, given the economy's downward spiral that was accelerated by the attacks on New York and Washington.

Still, the fear is that the rate cuts, which can take up to 18 months to have an affect by spurring investment and spending, won't provide any immediate relief to the economy, but could eventually cause rampant inflation in 2002 or 2003. That's a danger when corporate and household demand increases outpace the gradual boosting of interest rates, leading to a vicious cycle of overspending, higher prices and higher wages.

In order to prevent that, the Fed would need to raise rates nearly as fast as it lowered them, which is difficult to do, economists said.

In the meantime, the economy could face a "liquidity trap," in which businesses and consumers won't borrow despite extremely low rates, rendering monetary policy powerless. This is the situation in the struggling Japanese economy, which boasts zero percent interest rates yet continues to wallow in recession.

And observers are worried the same might happen here, given the tepid response of businesses and banks to taking and making loans since January, when the Fed started slashing the 6.5 percent overnight lending rate — the rate banks charge one another for short-term loans.

On Tuesday, many major banks, including those in Hawai'i, immediately reduced their prime lending rates — which started the year at 9.5 percent — to 5 percent following the Fed announcement.

"We've told our clients to be very cautious in this climate," said Gary Giumetti, president of McTevia & Associates, Inc., a consulting firm in Eastpointe, Mich., which is trying to help dozens of companies weather the downturn.