Since taking office in 1987, Federal Reserve Chairman Alan Greenspan has been known for his willingness to take quick and decisive action when confronted by a crisis. Now he has done it again. Facing the prospect of a rapidly slowing economy, a shrinking manufacturing sector, and a fast-declining stock market, Greenspan on Jan. 3 led the Federal Open Market Committee in an aggressive half-percentage-point reduction in interest rates--a move that sent the stock market soaring.
This rate cut was much bigger and came sooner than most economists expected. But just as he did during the 1990s, Greenspan has shown far more faith in the productivity-enhancing effects of technology than most forecasters. During the boom years, Greenspan kept rates low, banking on strong productivity growth to hold down inflation despite strong growth and low unemployment. Now, as the economy turns down, the Fed is counting on technology to reduce the danger that an interest cut will reignite inflation. The Fed's announcement of the rate reduction noted that "there is little evidence to suggest that longer-term advances in technology and associated gains in productivity are abating."
In the short run, the reduction in rates breaks the gathering mood of market panic. With the Fed actively cutting rates, there is less chance of a severe downturn and less need for investors to sell. That, in turn, will increase the incentive for companies to boost spending on new equipment, while making it easier for them to raise money in the capital markets. Moreover, a more buoyant U.S. economy will make it less likely that Asia and Europe will fall into a deep slump.
To be sure, the Fed's job is far from done. There's still a lot of negative momentum in manufacturing, retail sales, and the technology sector. It is certain that the next couple of months will see a string of negative earnings reports. As a result, it seems likely that the Fed will have to cut again sometime this spring.
The fall in the Nasdaq was a necessary correction to speculative excesses in tech stocks. But the New Economy did not end when the stock bubble burst. Quite the contrary. By cutting rates when he did, Greenspan has shown that he understands that there is a big difference between genuine New Economy productivity gains, which are continuing, and overinflated stock prices. And that's terrific news for the U.S. economy.