Commentary: It's the Wait-and-See Rate Cut

With five half-point cuts in the pipeline, Greenspan figures a quarter-point will do

By Rich Miller and Laura Cohn

When Federal Reserve Chairman Alan Greenspan launched the central bank on its campaign to cut interest rates in January, 2001, he was determined not to repeat the mistake he made during the recession 10 years earlier. Back then, Greenspan's Fed at first hesitated to ease credit, then reduced rates in baby steps of a quarter-percentage-point each. This time, the monetary maestro has pursued a different strategy. He cut rates early and often--five straight times in half-point increments.

Now, it's time to sit back, watch, wait, and hope all that stimuli will do the trick. That's the message of the Fed's decision to cut rates by just a quarter-point on June 27. Is a quarter-point too little, too much, or just right? While a growing camp at the Fed has increasingly argued that it's time to turn off the tap, the truth is that no one, including Greenspan, can yet know.

DELAYED REACTION. It usually takes six months or longer for changes in interest rates to affect the economy. By that measure, much, if not all, of the 2 3/4 percentage points in monetary juice that the Fed has pumped into the economy has yet to work its wonders on growth. And don't forget about the $38 billion in tax-refund checks Uncle Sam will start mailing out at the end of July. "What Greenspan is saying is: `We've got a lot in the pipeline, it hasn't kicked in yet, just be patient,"' says Stephen D. Slifer, chief economist at Wall Street broker Lehman Brothers.

At least initially, the financial markets seemed prepared to give Greenspan & Co. the benefit of the doubt. After selling off briefly on disappointment that the rate cut wasn't bigger, stock prices recovered, to close on June 27 virtually unchanged.

But it would be wrong to read into the Fed's latest action that the central bank is by any means confident about a second-half rebound. Nor is it ready to call it quits on rate cuts. "This was not a vote of confidence in the economy," says Louis B. Crandall, chief economist at New York-based consultant R.H. Wrightson & Associates. Indeed, the short statement the Fed issued announcing its reduction was a litany of economic woes: falling corporate profits, declining business investment, weak consumer spending, and slowing growth abroad. And don't forget that the quarter-point cut, small as it was, was the Fed's sixth move in six months--the most concerted rate-cutting crusade by the central bank in nearly 20 years.

If anything, the quarter-point rate cut--and the terse statement released by the central bank explaining the move--suggests that Fed policymakers are more uncertain than ever about the economic outlook. There's no doubt it's a confusing time. What the U.S. has is a Jekyll-and-Hyde economy that continues to send out conflicting signals. Consumer confidence is holding up, the housing market remains strong, and energy prices are falling sharply after hikes put a big dent in growth over the past year. Yet manufacturers, particularly high-tech companies, are still mired in their own brand of recession. And corporate profits in general remain under pressure, prompting companies to slash spending and pare payrolls.

NO ONE KNOWS. There's also uncertainty about when the double dose of monetary and fiscal medicine will take effect--and how much of an impact it will have when it does. Traditional macroeconomic models suggest that it should be enough to put the economy on a recovery path later this year. But the unusual nature of this slowdown--triggered by a stock market bubble that burst and an investment boom gone bust--may mean that the rate cuts won't pack as much punch as they did in the past. "The Fed has done about as much as anybody could reasonably expect," says Allen Sinai, chief global economist at Boston-based consultant Decision Economics. "Yet I remain uneasy about the outlook."

So, too, do Greenspan and the rest of the Fed. Although they're hoping their big monetary push will lift the economy out of its doldrums in the second half of the year, they're not counting on it. And they stand ready to act again if it doesn't.

Miller and Cohn cover economics from Washington, D.C.

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