An old fear about monetary policy is cropping up. The concern arose during the 1990-91 recession and in the even more severe 1981-82 slump before that: This cycle is different from the past, the theory goes, so lower interest rates will not revive growth. The Federal Reserve is, in effect, pushing on a string.
The argument's current version goes like this: The Fed undertook the most aggressive easing in the postwar era, but it hasn't worked, because the economy's Achilles' heel is overinvestment by businesses. Overcapacity is a supply problem not conducive to demand stimulus like lower borrowing costs. Moreover, the post-September 11 drop in stock prices and higher corporate bond yields have retightened financial conditions and offset the Fed's earlier stimulus. In short, the U.S. faces a Japanese-style crisis of nearly free money that no one wants to borrow.
True, this business downturn is unlike any other. The unprecedented uncertainty among businesses, consumers, and investors makes it likely that any progress toward recovery ground to a halt in the third quarter. The economy will most likely contract in the fourth quarter, and the growth outlook for 2002 is murky at best. The immediate impact of the September 11 shock will make the data in coming weeks look terrible.
This bad news will stoke criticism of the Fed, even though they have responded to the tragedy forcefully by flooding the financial system with liquidity and by cutting the federal funds rate by a half-point on both Sept. 17 and Oct. 2 (chart). At 2.5%, the funds rate is now the lowest in almost four decades.
QUESTIONS ABOUT the efficacy of Fed policy proved to be overblown in the two previous recessions, and that will be the case again this time. First of all, monetary policy takes time to work. The primary impact of lower rates is not directly on demand. Lower rates trigger a reliquification process in which consumers and businesses use cheaper borrowing rates to pay off old debts and shore up their balance sheets.
Second, the latest data on industrial activity and consumer spending suggest that the economy was finding a bottom in late August and early September, and that previous rate cuts were beginning to work. Lastly, Japan's problems are structural and more severe than those in the U.S. The bottom line: Monetary policy will work--and it will get help from fiscal policy.
Here's why. Fed policy acts with a lag, and the data were already showing that the rate cuts of earlier this year were directly responsible for companies and consumers getting their finances into better shape prior to September. Corporations had issued a record volume of bonds this year as long-term financing rates fell. Cash flow of nonfinancial companies actually rose 9% in the second quarter, according to an analysis of recent Fed data by economists at J.P. Morgan Chase & Co.
Corporate belt-tightening was paying off. Commerce Dept. data show that the erosion of profits has become progressively smaller since the end of 2000. Earnings of nonfinancial companies fell only $10 billion in the second quarter from the first-quarter level, compared to a $63 billion decline in the fourth quarter.
Homeowners, meanwhile, are taking advantage of lower rates to refinance their mortgages, the biggest debt owed by most households. Consumers are either tapping their home's equity for extra cash or lowering their monthly mortgage payments. Plus, consumers are using their tax rebates to save more or pay down existing debts (chart). That has put consumers in a better position to keep spending.
IN FACT, THE FED'S RATE CUTS were producing results. The pre-September 11 data show that the economy, while still weak, was looking firmer in key areas, making it less vulnerable to the impact of last month's shock. Real consumer spending, as measured in the GDP data, was on a track to grow at an annual rate of 3% or more in the third quarter, prior to the attacks. That would have been the best consumer showing in a year. September car sales, while down from August, held up far better than anyone had expected.
The factory sector was also showing signs of stabilizing, at least outside of tech equipment. August capital-goods orders posted their first increase in five months. In September, the purchasing managers' index of industrial activity dipped to 47%, from 47.9% in August, but remained above its average of the first half (chart). For the second month in a row, the purchasers said that production increased and orders rose, a sharp departure from previous months. Although some survey responses were received before September 11, the majority were received afterward. Plus, the purchasing managers' September index of nonmanufacturing activity, mostly services, rose sharply. All of this shows how Fed policy works with long lags that vary from business cycle to business cycle.
THAT LEAVES THE FINAL ARGUMENT of the string-pushing theory: that the U.S. has slipped into a Japanese-style liquidity trap. But, again, this holds no water.
Japan has long-run structural problems that have caused a breakdown of the investment and growth process. A centrally planned and heavily regulated economy makes Japan less efficient and less responsive to policy. In contrast, long-run growth prospects in the U.S., fueled by technological progress and faster productivity, remain bright. The decline of government regulation has spurred risk-taking and innovation in the U.S. and has streamlined distribution systems.
Equally important is the fact that Japan's banking system is in a shambles: Banks are already awash in nonperforming loans, and there is no incentive to make new loans. U.S. banks are in excellent shape compared with both their Japanese counterparts and their condition in the 1990-91 recession, when the savings and loan crisis did threaten the banking system. That crisis was one of the "headwinds," as Fed Chairman Alan Greenspan put it back then, that the Fed had to fight. But the Fed cut its overnight loan rate from 6% to 3%, banks were reliquefied, and the economy sailed on.
The headwinds are different this time, but they are no less amenable to Fed action. After the Oct. 2 cut, the inflation-adjusted funds rate is down to about zero, which is not unusual in a recession or immediately following. The Fed kept the real funds rate negative for almost two years, in 1992 and 1993, in order to assure a recovery. This time around, policymakers seem likely to cut the fed funds target to at least 2% in coming months, meaning that the real rate will be negative for the rest of the year.
Absent the September 11 tragedy, the action of the Fed in early 2001 would now be more evident. The naysayers notwithstanding, the massive amount of monetary stimulus already in place will pull this economy out of its contraction. But even the Fed could not protect the economy from such a horrible shock.
By James C. Cooper & Kathleen Madigan