What Greenspan Must Be Thinking

Cut too much, the dollar dives. Too little, and markets tank. That makes a quarter-point slice the safest course -- and the most likely

By Margaret Popper

If we're on the cusp of a mild economic recovery, and various economic data are hinting that's the case, then the Federal Reserve is in a most delicate position. It doesn't want to strangle a recovery at birth, but it also doesn't want to inject so much liquidity into the system that it has to spend next year raising interest rates to prevent inflation from taking off. With its last rate cut of a quarter percentage point in June, the Fed renewed its predisposition toward a cautious monetary policy.

At the same time, Wall Street is getting very nervous. The full effect of the Fed's six rate cuts so far this year have yet to kick in. Investors are clamoring for 50 basis points (half a percentage point) of Fed easing. The capital markets have already priced in a minimum of a 25-basis-point cut. If they don't get it, the bottom could fall out of the market, and there would be hell to pay in economic terms.

A case can be made for a half-point rate cut now (see BW Online, 8/17/01, "Please, Mr. Greenspan, Surprise Us Again"). But despite the pressure, it's unlikely the Fed will cut the federal funds rate -- what banks charge each other for overnight loans -- more than 25 basis points at the Aug. 21 meeting of the Federal Open Market Committee (FOMC), the Fed's policy-making arm.


  Why? Several factors should soon begin to boost the recovery without Fed intervention, among them falling energy prices, a weakening dollar, and U.S. consumers receiving their federal tax-cut refunds. A 25-basis-point cut will be enough to assure investors that the Fed is still on the case, but not so much as to risk precipitously weakening the dollar or planting the seeds of inflation a year down the road.

The Fed has learned its lesson about how factors outside its control can distort the effects of monetary policy. In the second half of 2000, after 18 months of Fed tightening up interest rates, rising energy prices and uncertainty over who would win the U.S. Presidential election very nearly threw the economy into reverse. While the Fed isn't likely to risk a stock market revolt by not cutting rates at all, neither are the central bankers prone to put the pedal to the metal.

Plenty of pump-priming has already been done that hasn't really had a chance to work yet. "In the view of the FOMC, you can sight a lot of [economic] stimulus in the pipeline," points out Christophe Bianchet, an economist at Credit Suisse Asset Management. "There is the tax cut and the drop in energy prices. The Fed will have to wait and see how a 300-basis-point easing plays out." There has already been 275 basis points since Jan. 3. With an additional 25 basis point trim, the fed funds rate will be at 3.5%. Back out inflation, and the real fed funds rate is down to 0.8%.


  Even so, a quarter point sure seems paltry to many an investor. "Portfolio managers across America are down on our knees crying, 'Alan we need you! Give us 50!'" quips Ed White, a senior vice-president and director of equity investing at Boston-based money manager Gannett, Welsh & Kotler. Although White acknowledges that the stabilization in jobless claims from June to July and the most recent improvement in industrial-production numbers may indicate a turn in the economy's direction, he doesn't see much in the overall economic picture to get excited about.

The main problem with both the economy and the capital markets remains weakness in the tech sector, says White. That should persist for at least another year. The anemia in this sector has dampened the effects of the Fed's monetary policy so far this year, according to Anthony Richards, a managing director and co-head of fixed income at Chicago-based money manager Brinson Partners. "People like rules of thumb, like 'Six months after the Fed starts easing you should begin to see the full effects of monetary policy,'" he says. "But the unwinding of each economic cycle is different, and this one came about because there was too much capital spent on projects that shouldn't have been."

Because of the continued weakness in tech, the market has priced in another 25-basis-point rate cut by December, which is evident in the fed funds futures trading and the strengthening euro, says Richards. One key element in the economic balance is the dollar. Until recently, the greenback continued to appreciate against the euro and other currencies because of the comparative strength of the U.S. economy and capital markets.


  Recently the dollar has weakened against the euro, although not the yen. That's good news for U.S. exporters because it makes U.S. goods cheaper overseas. But it's a development the Fed has to keep an eye on. If the dollar drops too fast, it puts inflationary pressure on the U.S. economy -- and Greenspan & Co. want no part of that. The Fed might even be emboldened to raise rates if inflationary pressures begin to surge. But for the Fed to reverse policy direction, the dollar would have to drop dramatically against the euro. That's unlikely with the world economy slowing. But the falling dollar certainly gives the central bankers an excuse to cut rates at a more conservative pace.

It may be nerve-racking to watch the Fed inching its way along the path to economic recovery. But in this walking-on-eggshells environment, Greenspan & Co. may not have much choice. No cut would surely spook investors, and a half-point reduction might send a signal that the central bankers are truly worried. A cut of 25 basis points could prove to be the only prudent move.

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

Edited by Beth Belton

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