Commentary: Forget The Rulebook. Times Call For A Rate Cut

What should the Federal Reserve be doing these days? Unemployment is below 4% and core inflation is running at a 2.5% rate--up from 1.9% a year ago--despite six rate hikes. The old rule book says the Fed ought to keep tightening monetary policy. At a minimum, conventional wisdom holds that interest rates should be kept steady to avoid an inflationary spiral.

But Fed Chairman Alan Greenspan needs to seriously consider cutting rates if the stock market keeps sliding precipitously. The reason is simple: In the New Economy, he should be as concerned about the prospective funding squeeze on small innovative companies as he is about tight labor markets.

Keeping inflation under control is important, but the plunging Nasdaq stock index and the prospect of slower economic growth will make it harder to raise money even for companies with good ideas. That will deprive the economy of one of its prime engines of growth. Moreover, it will become more difficult to restart the venture capital technology funding cycle if the Fed waits too long to cut rates.

DOT-COM LAYOFFS. There's little doubt that the New Economy has thrived on easy access to capital for startups. Venture capital, a critical source of such funds, is running at an annual rate of more than $100 billion, according to the National Venture Capital Assn. That's almost as much as households borrowed in consumer credit over the past year.

But venture capital and other types of young-company funding, such as initial public offerings, are highly sensitive to financial and economic conditions. The 35% drop in the Nasdaq since March is already starting to crimp capital funding for new companies, leading to many fewer IPOs and a rash of dot-com layoffs and shutdowns.

So far, this sort of winnowing is exactly what is needed. The winners get funded, and the excess gets drained out of the system.

But if the market keeps plunging, even ideas and companies with real potential will get less money. In times of crisis, financial markets are almost always driven by a contagion effect, where the stocks of good companies are hit almost as hard as the those of bad ones. Already, the drop in tech stocks has hit not just losers but such strong companies as Cisco.

Its stock has lost a third of its value since March. If this broad-brush decline persists, the result will be lower financing levels, less innovation, and slower productivity growth.

In recent months, the stock markets have fallen prey to the Fed's determined efforts to drain liquidity from the economy. M1, the money supply measure most directly controlled by the Fed, has been falling since early 2000, and with a lag, so has the Nasdaq index. Both the European Central Bank and the Bank of Japan have also hiked rates, despite weakness in their respective economies.

As global liquidity dries up and growth prospects dim, investors will increasingly shift to lower-risk investments, favoring larger, more established companies. That's what happened in the late '80s, when Fed tightening made it much harder for small companies to get funding on the stock market and from venture capitalists.

To be sure, the funding crunch has not yet done real harm. Venture-capital firms are still flush with cash, and many new companies that received funding in the past six months have plenty of money in the bank. But if the stock market does not pull out of its recent nosedive, then money will get scarcer for all but the most profitable startups.

Commentary: Forget the Rulebook. Times Call for a Rate Cut

If the Fed waits to cut rates until the tech downturn is in full swing, it will be too late. The Fed doesn't influence venture capital and IPO funding as easily as it does bank lending. As a result, it takes more time for higher interest rates to curb a venture-capital boom, and more time for lower rates to revive the market for investments in new companies.

No one disagrees that higher inflation should be avoided. But losing the benefits of cheap capital for new ideas could pose a bigger problem for a tech-driven economy. If the Fed forgets that, it risks doing harm while trying to do good.

Before it's here, it's on the Bloomberg Terminal.