Posted on: Friday, June 20, 2003
Another Fed rate cut expected
By John M. Berry
There is agreement among investors and analysts that a rate cut is coming, but there is disagreement about whether policymakers will lower their 1.25 percent target by a quarter-percentage point or by a half point.
The latter seems to be more likely as a sort of exclamation point to emphasize that the officials believe this will be the final step that, coupled with the income tax cut that will show up in workers' take-home pay next month, will put the economy on a strong, sustainable growth path.
Fed Chairman Alan Greenspan, who gave the first hint that he was contemplating another rate cut in testimony before a congressional committee on May 21, referred then to such a step as "taking out insurance."
"We believe that because in the current environment the cost of taking out insurance against deflation is so low, that we can aggressively attack some of the underlying forces, which are essentially weak demand," Greenspan told the committee.
Several other Fed officials have expressed similar views in recent weeks. By "cost" Greenspan meant the risk that another rate cut could so stimulate economic activity that it would cause inflation to become significantly worse. But in this instance, such an outcome would almost be welcome.
A Fed rate cut next week would be the 13th since January 2001 on the eve of a recession when the rate target was 6.5 percent. The Greenspan-led Fed cut rates aggressively as the economy contracted through that year, and growth resumed in 2002. But to the surprise of economists and policymakers, the recovery has been halting and "jobless" despite huge doses of monetary and fiscal stimulus. The U.S. unemployment rate, which had fallen to 3.9 percent in the fall of 2000, was 6.1 percent last month.
Now, again, many forecasters are predicting that economic growth will accelerate. They are saying the pickup will occur in the second half of this year, to a fast, sustainable pace that will begin to add jobs and put much of the nation's idle production capacity back to use.
Greenspan and his central bank colleagues don't necessarily think those forecasts are wrong; they just aren't convinced they are right.
Gary Stern, president of the Minneapolis Federal Reserve Bank, said in an interview Monday that when he talks with bankers and business executives around his sprawling district, which runs from the Upper Peninsula of Michigan to the mountains of western Montana, "the tenor of the conversations is clearly more upbeat than they were at the turn of the year. It's not all bright and sunny, but the sense I got is that business is starting to improve."
However, Stern stressed, "I do not want to exaggerate this. ... It is certainly not reflected in the current quarter's data. Will it be reflected in the third quarter? Who knows?"
What has added a sense of urgency to next week's policymaking session is the rapid unexpected decline in the U.S. inflation rate this year. The core consumer price index, which excludes volatile food and energy prices, was up at only a 1 percent annual rate over the past three months.
Another measure closely followed by many Fed officials, the core price index for personal consumption expenditures, rose at about the same 1 percent annual rate in the six months ended in March, and analysts are predicting a similar number for the current quarter.
The Fed's concern is the "minor probability" that this drop in the inflation rate could turn into a deflation, which Stern defined in a talk this week as "a sustained period of decline in a broad measure of prices." There is a consensus among policymakers that the probability of that happening "is low but the consequences if we experience it possibly would be severe," he said.
In a deflation, declining prices could force employers to reduce wages, make it harder for borrowers to repay debts, seriously hurt economic growth and make it more difficult for the central bank to use monetary policy to stimulate a slumping economy. That's because interest rates cannot effectively fall below zero. During a deflation, inflation-adjusted interest rates could therefore still be positive and restrain economic growth even when the nominal interest rate was zero.
Fed officials have said they could use other methods to pump money into the economy even if the overnight rate fell to zero. However, Greenspan has said the lack of experience in dealing with such a situation means the Fed cannot be certain how things would work out, so it is far better to avoid a deflation in the first place.
"The Fed is not panicking, and believes the economy will pick up, most likely rendering the deflation issues less relevant in the longer run," said economist Peter Kretzmer at the Bank of America in New York. "Further, the Fed is confident it has the nonstandard tools to end a deflation."
But Kretzmer, like many analysts, expects the Fed to lower rates next week, in part because the officials' recent statements about deflation have convinced financial markets such a cut is on the way. Balancing market expectations with some signs that the economy stabilized last month, the Fed is likely to lower the target by a quarter point, he predicted.
In contrast, economist Ken Kim at Stone & McCarthy, a financial market research firm, said he expects a half-point cut, given the notion of "insurance" behind the action and the absence of worry about excessive inflation.