It's Not Much Of A Cut, But It's A Cut

In mid-July, a senior Federal Reserve official relaxed on the couch in his office and listed the reasons the central bank could take it easy for the summer. The economy was recovering but not fast enough to revive inflation fears. Financial markets were quiet, and so was the bickering among Fed factions. "We have a pretty good period ahead of us," he said. But, he added, "you can't predict this recovery very well."

No kidding. Three weeks later, the Fed was buffeted by a sharp drop in the money supply, declining employment, and renewed pressure from the Bush Administration for easier money. On Aug. 6, the Fed responded with a cut in a key determinant of interest rates--the cost of federal funds, or overnight loans between banks. While the drop from 5.75% to 5.5% was small, it was the Fed's first easing since Apr. 30. "The economy is very weak, and it desperately needed this," says Robert A. Brusca, chief economist at Nikko Securities Co. International.

RALLIES. Wall Street welcomed the move as a signal that the Fed was trying to head off a second dip into recession. The Dow Jones industrial average finished the day up 38.24 points. Bonds also rallied, despite a heavy supply of new issues. "The stock market liked it, the bond market liked it, business liked it, President Bush liked it," said Joseph A. Wahed, chief economist at Wells Fargo Bank. "I only hope the Fed liked it enough to do it again."

Inside the Fed, however, officials weren't pitching their move as the start of another round of recession-fighting. "This was a technical move to execute existing policy," a top official insists. The central bank hasn't quit trying to squeeze out inflation. Nor is it wavering in its belief that a modest recovery is on the way. Its regional economic survey, released on Aug. 7, concludes that "national economic conditions continue to improve, but at a slow, uneven pace."

Against that backdrop, a slide in the money supply had Fed officials asking if they were doing enough to support the recovery. M2, which measures currency and checking, savings, and time deposits, dropped at a 2.8% annual rate from June to July. As a result, M2 had grown at a 2.7% rate since December, close to the 2.5% bottom of the Fed's target range. Meanwhile, the Labor Dept. reported a loss of 51,000 jobs in July, accompanied by slow growth in labor costs (charts). "Money alone wasn't enough of a reason to ease," says a Federal Reserve Bank president who's a hawk on inflation. "But with the employment numbers and soft inflation, it seemed like we could buy some recovery insurance at a modest cost."

DOLDRUMS. After Friday's jobs report, Fed Chairman Alan Greenspan spent the weekend calling other Fed officials. All the central bank's camps--monetarists, watchers of economic statistics, and inflation superhawks--saw the need to move. Greenspan decided to act swiftly, rather than wait until the Aug. 20 meeting of the policy-setting Federal Open Market Committee, because a rate cut now would have more impact than one in late August's market doldrums.

On Aug. 20, the key issue will be: Has the central bank done enough? The latest move probably won't spur the torpid economy into a new spurt of activity. Home buyers and blue-chip corporate borrowers will feel the effects immediately: The rate on 10-year Treasury notes, a key indicator of mortgage rates, fell to 7.94% at the Aug. 7 auction, down from 8.01% two days earlier. But other borrowers won't be so lucky. Bankers are likely to use the Fed's move to bolster profits, not cut loan rates.

To stimulate business--and to prevent the double-dip recession the GOP fears--the Fed may have to cut again in September. That step will be harder because the central bank also would have to cut its highly visible discount rate, now at 5.5%, to keep it below the Fed funds rate. Another cut would also raise fears the Fed is staying easy too long.

History shows that past Feds have overheated the economy by doing just that. But history also shows that "the Fed has to overdo its easing policy a bit," says Robert J. Barbera, chief economist at Lehman Brothers Inc. "The economy needs enough thrust to escape gravity, before it can cruise." The Greenspan Fed might be better off with one easing step too many than one too few.

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