Greenspan Cuts More and Gets Less

As the Fed chairman weighs another rate reduction, he knows monetary policy doesn't pack the wallop it once did

By Margaret Popper

Take a ringside seat: The Federal Open Market Committee (FOMC) meeting set for June 26 and 27 has all the excitement of a high-wire act. Greenspan the Magnificent has to traverse the heights on a tightrope between between bond-market fears of inflation and stock-market fears of a worsening earnings picture. If the bond market doesn't start to see a slowdown in rate-cutting soon, long-term rates could jump up on inflation fears, choking off credit. And if Wall Street is disappointed, the markets could take a nosedive, destroying consumer confidence.

Actually, what the Fed does over the next few FOMC meetings may well determine whether it can get the economy out of the slowdown. The betting among most economists is that Greenspan can do it, but it will take another 50 basis points of rate cutting between June and August. Add to that checks showing up in mailboxes across America this summer from the Bush tax cut, the stabilization of the stock market, and surprisingly happy consumers, and Greenspan & Co. may well be able to keep unemployment at 5% or below. That should stave off a recession.

However, even if the Fed emerges a hero, it's also becoming clear that the blunt instrument of monetary policy has to be wielded with more brute force today than ever before. The Fed's job has always been more of an art than a science, says Mary Farrell, chief U.S. strategist at UBS PaineWebber. But, she adds: "In the last five years, it has gotten harder than ever."


  Look at the last tightening cycle. Most market watchers agree that if the Fed hadn't ratcheted up interest rates through May, 2000, as hard as it did, it might not have have popped the dangerous tech bubble. But without the Fed's heavy-handed treatment, the economy wouldn't be facing its current predicament, either.

Once it succeeded in pricking the valuation balloon, critics say, the Fed was too slow on easing back. "Adding the headwinds of a half-point boost in May last year was like hitting the economy between the eyes with a two-by-four," says Harvey Rosenblum, the director of economic research at the Federal Reserve Bank of Dallas. "In retrospect, we didn't need to put in the extra half point, but there were some scary numbers last spring on inflation."

By the time it was clear that the economy was truly slowing, it was November and a Presidential election was hanging in the balance. The Fed was in no position to take action. "The electoral outcome had not been decided, and that is a time for the Fed to lay low, not make loud bull moves," says Rosenblum. "Could the Fed have eased in December? Yeah, probably. But is there a big difference between December and Jan. 3 [when the Fed first cut rates]? Probably not."


  Since January, Greenspan has tried -- almost feverishly -- to make up for lost ground. "The Fed has eased twice as much [in this loosening cycle] as it did in the 1990-91 recession," observes Ethan Harris, co-chief economist at Lehman Brothers in New York. But given that the Fed has cut deeper and faster than ever before -- a full 2.5 percentage points in less than six months -- the economy has showed the same slowness to react to easing that it did to tightening.

"It has been a holding action," says Harris. "It kept the housing market going, held up consumer confidence, and put a floor under the stock market. But it hasn't got us into recovery yet."

This protracted reaction time is due to some big structural changes in the economy. One is the shift away from manufacturing that has to borrow a lot to invest in capital improvements and toward services, where the biggest cost is labor, which is variable. Because service sectors don't have to borrow as much, interest-rate fluctuations don't affect service companies' ability to grow in the same way.


  Another key difference is increased globalization. It used to be that the economic cycles of different countries didn't necessarily move in tandem. Nowadays, they tend to run more in sync because of increased economic integration. That means it's harder for corporate earnings to pull out of a slump, since foreign markets can't offset weak demand at home. "We're in a synchronous slowdown," says the Dallas Fed's Rosenblum. "Latin America, Europe, and even some Asian countries are slowing down. Projections are that economic growth for the global economy is going to be a couple of percentage points lower than it was last year."

Such structural changes don't always spell doom and gloom. The business cycle has changed, thanks in part to the productivity gains created by the tech boom. "From 1946 to 1981, on average, we had a recession every four years," points out UBS PaineWebber's Farrell. "Since 1981, we've had one mild recession." Also, inflation appears to be less of a threat than ever before. Increased competition from globalization has taken pricing power away from companies so that when their costs rise, they increase productivity, not prices, says Rosenblum.

At the same time, the labor supply has become so flexible -- people shift from job to job more easily than in the past -- that historically low unemployment levels don't necessarily translate into wage-driven inflation, he says. So while Greenspan may have to take more drastic action to get a reaction out of the economy, in the absence of real inflation fears, he also has more room to move.


  Still, the Fed has to be careful about how the cuts affect the capital markets. Judging by Fed Funds futures, the bond market expects a 25 basis-point cut in the Fed Funds rate at the end of this month. "There's a 100% likelihood of a June cut of 25 basis points," says Joseph Sunderman, manager of research and development at Schaeffer's Investment Research. "There's a 50% likelihood that the June cut will be 50 basis points."

Given the woeful state of corporate earnings, the more stimulus through rate cuts, the better, as far as the stock market sees it. "The data justifies another 50 basis points [cut at the June meeting]," says Lehman's Harris. "The only argument I've heard for 25 basis points is simply that the Fed's rate cutting has got to slow sometime."

In his recent speeches, Greenspan has been less concerned about inflation and consistently concerned about the depressing economic data. So don't be surprised if he delivers another, more forceful, ax chop. Perhaps another 50 basis-point cut is the shock the economy needs to shake its torpor.

Popper covers the markets for BW Online in our daily Street Wise column

Edited by Douglas Harbrecht

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