The Case for a Rate Cut Now

Why wait til the Fed's next meeting, in mid-May? Economic, psychological, and tactical reasons say this is the time

By Rich Miller

Judging by what Federal Reserve policymakers have been saying on the hustings recently, a quick cut in interest rates is the farthest thing from their minds. In speech after speech, the monetary mandarins have pounded home a simple message: The economy is on the mend and is poised for a pick-up in the second half of the year. "Their rhetoric doesn't suggest they're ready for an inter-meeting rate cut," says Stephen Stanley, senior market economist at bond dealer Greenwich Capital.

Indeed, St. Louis Fed President William Poole virtually ruled out such a reduction before the central bank's next scheduled meeting on May 15. "Rate changes should occur at meetings, as a general matter," Poole said on Apr. 10. "There are compelling times when quick action is necessary, but this is not one of them."

Perhaps Poole and his fellow Fed policymakers should think again. There are good reasons -- economic, psychological, and tactical -- for the Fed to lower rates now, instead of waiting until May 15 to act. It would be one of the smartest moves yet for a Fed that at this point seems as determined to keep the economy out of recession as it is to keep inflation under control.


  Sure, the economy isn't in a free-fall. But growth is so weak -- likely to be under 1% in both the first and second quarters -- that even the Fed's optimists agree that lower rates are needed to give the economy an added boost. In the statement they released after cutting rates by a half percentage point on Mar. 20, Fed policymakers held out the possibility that they might ease credit further before their next meeting on May 15.

Why not go ahead and do just that? When the Fed last cut rates between meetings on Jan. 3, it did so to bolster consumer confidence. And the move worked. After declining precipitously at the end of last year, consumer confidence has stabilized. That's important because consumer spending accounts for two-thirds of the economy.

Now the Fed needs to go to work on business confidence. The steep slowdown has soured sentiment in corporate suites so much that business leaders are talking -- and acting -- like the economy is already in a recession. Latest case in point: Motorola, which reported its first quarterly loss in 16 years on Apr. 10. "We see a continuing downturn in the U.S. economy," Motorola CEO Chrstopher B. Galvin said in a statement accompanying the company's first-quarter report. "The high-tech sector, which has been hard hit, is already in a recession," he added.


  The danger is that all that gloom-and-doom talk becomes self-fulfilling, that businesses turn so cautious that they concentrate on conserving cash and slash spending on efficiency-enhancing equipment. "Companies are becoming wary of making commitments of any sort," says Louis B. Crandall, chief economist at consultant R.H. Wrightson & Associates. That hurts the economy in the short-run by crimping growth and raising the risk of a recession. But it also damages the economy in the longer run by undercutting the productivity performance that has been the source of country's prosperity in recent years.

Of course, there's no guarantee that a sudden, surprise rate cut would be enough to revive business leaders' "animal spirits." But it stands a good chance of succeeding precisely because it would be unexpected. The mini-rally in the stock market over the last week -- combined with all the happy talk from Fed officials --has convinced most investors and business people that the central bank will wait until May 15 to reduce rates.

If the Fed instead surprised the market with a rate reduction in the next few days, it could act as a powerful tonic for battered business confidence. The central bank would also get added oomph from an early rate cut because it would be working with the stock market, rather than against it. When share prices were falling relentlessly, the risk was that pessimistic investors would give the thumbs down to the Fed, no matter what it did. But now that the stock market is showing at least some tentative signs of stabilizing, there's less of a risk of that happening.


  It's a little like currency-market intervention. If central banks try to stop a currency that's in free-fall by buying it on the foreign exchange market, they're not likely to succeed. But if they wait until the currency looks to be stabilizing and then act, their chances of success are much greater.

So will the Fed cut rates before its next meeting? Right now, the smart money -- and the chatter from the central bank -- suggests not. We'll probably know for sure in the next few days. Next Tuesday, Apr. 17, marks the midpoint between the Fed's last meeting and its next one on May 15. If the central bank hasn't done anything by then, the chances are it will wait until mid-May to act. But Alan Greenspan is a very smart man. Stay tuned.

Miller covers the Fed for BusinessWeek from the Washington bureau

Edited by Douglas Harbrecht