"The Fed Wanted to Nip the Panic in the Bud"

S&P's Michael Englund says the big Jan. 3 rate cut shows Greenspan & Co. are in a hurry to keep a crisis mindset from setting in -- and that more cuts could come soon

Just when you think you know what Fed Chairman Alan Greenspan is going to do next, he surprises everyone. On Jan. 3, the Federal Reserve cut interest rates, reducing the key fed funds rate -- the rate at which banks make overnight loans -- by one-half percentage point, to 6.0%. Stocks exploded on the positive news, triggering trading curbs.

In a statement, the central bank said it was acting "in light of further weakening of sales and production, and in the context of lower consumer confidence." Greenspan & Co. cited "tight conditions" in some areas of the financial markets, plus high energy prices. And perhaps most significant of all, it maintained its easing bias, indicating it could cut rates further -- and soon.

What's next? Business Week Online correspondent Alan Hughes caught up with Michael Englund, chief market economist for Standard & Poor's. Here are edited excerpts from their conversation:

Q: The Fed moved suddenly -- many observers felt they'd wait until at least after the release of Friday's employment report -- and decisively. Were you surprised by the timing?


Clearly, the Fed tried to create an environment [for easing] in December, with Greenspan's speech prior to that. They were in a heightened state of alert regarding the economy. So there was an ongoing perception that the Fed had created an environment where they can ease inter-meeting without much flack from the market.

Q: What about the size of the ease? Was that unexpected?


Well, that was also a surprise. The fed funds futures market was counting about a 40% likelihood of an inter-meeting easing, but that would be at 25 basis points roughly some time early in the month. That's also interesting because the probabilities seemed to line up -- but the Fed ease was twice as much as expected. So we were really surprised on both fronts. We'll probably encourage people to expect further easing. The magnitude suggests that the Fed is in a hurry. So oddly, it may heighten the likelihood that they ease on the Jan. 31 meeting again.

Q: The Jan. 3 National Association of Purchasing Management report was shockingly weak. Did that prompt the Fed to pull the trigger?


Greenspan likes the NAPM report, and that was quite weak. It's also the case that, through the end of the month, bad weather hit much of the country, including New York. That was kind of icing on the cake. We knew that December would be a relatively weak month, but that pretty much sealed it. Now it's likely that 2001 will pretty much go down as a year with a harsh winter. So that tends to depress economic data in January. So I think the Fed knows they have a window where economic data will be weak. And we also have, at the same time, a market meltdown and the drop in the Nasdaq. The combination of all that probably left the Fed with a notion much like in 1998 [the last time it cut rates by a half-point].

I think it's the interplay for the Fed between a slowing economy and a declining stock market, and the perception that we may have more of a crisis mindset, which the Fed is attempting to address. The Fed wanted to nip the panic in the bud, make sure the market doesn't get too carried away with the perception that we were moving to a hard landing. So just as in 1998, I think the Fed wants to prevent a panic environment in the market.

I think if you step back more broadly, the economy isn't doing so bad, and the soft landing remains a likely scenario. If you look at '98, the economy not only didn't slow, it actually accelerated pretty sharply because the Fed eased. That goosed the economy. We never did see the negative-wealth effects on spending in that instance. But the positive effects of lower interest rates were pretty clear. So in that instance, the Fed's attempt to nip the panic in the bud also fueled growth. Whether or not that's what we'll see this time is unclear.

Q: So you think psychology is a big factor?


Definitely. The bulk of the economic effect is a lagged impact on the buy/lending process. Since 1998, the Fed has been trying to impact market spreads in the debt markets and impact credit available. That vehicle is through market expectations. If they can try to dissipate the crisis environment in the equity market and corporate bond market, they may have a more immediate effect on the economy through psychology, rather than this lagged effect that economists estimate.

Q: I'm going to ask you to go out on a limb here. When could they move again to cut rates, and how much do you think they might move?


We're going to assume a quarter-point at the January meeting, and we're going to assume another quarter point in March and assume that rounds it out with 100 basis points of easing, and that that'll be enough.

Q: How long do you think it could take for these rate cuts to have the desired effect on economic growth?


Well, generally interest-rate reductions as well as increases take about 6 months to 18 months to impact the economy. Generally, you would need a sizable interest-rate increase or decline. So today's action is more important in that it indicates a change in trajectory. The Fed is now moving to an easing mode. And there may be additional easings. So today's move isn't so important just because of the macro effect. It's more that this signals that the Fed is in an easing mode and may ease further. Maybe by the end of the first quarter, we'll see much lower rates. And that could have a more sizable effect on the market.

Edited by Will Andrews

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