Why Rate Cuts Still Work

Fears that monetary policy can no longer revive a sagging economy are seriously misguided. It can and it will. Just sit tight and watch

By Margaret Popper

If you're in the camp that has been demanding results from the seven Federal Reserve-engineered rate cuts since Jan. 3, take a load off and relax. When policymakers say it takes at least 6 to 12 months for the impact of an easing to begin to show up in the economic data, that doesn't mean that magically, six months to the day after the first easing action, the economy is going to recover completely.

Central bank action is really only a catalyst. The rest falls to the private sector, which has to clear out the excesses in the system -- regardless of whether interest rates are three percentage points lower. The Fed can't fill the void of capital spending simply by lowering interest rates. What its moves do is lower interest expenses to help corporations shore up their balance sheets.


  In fact, the Fed has no need to apologize for its performance thus far in this slowdown. By aggressively lowering the federal funds rate (what banks charge each other for overnight loans) by three percentage points since January to 3.5%, Greenspan & Co. have kept the rest of the economy from being overwhelmed by the collapsed tech sector.

Without the rate cuts, the U.S. would probably be in the throes of recession. The consumer would have retreated from the malls long ago, and the housing sector would have dropped off considerably. The Fed's objective for the foreseeable future is to inoculate the consumer side of the economy from what ails the business side -- and to do so without adding so much juice to the system that inflation flares.

So far the interest-rate maneuvers have worked to this end, albeit slowly. But the toughest period for the Fed is the current quarter. With capital spending still languishing, the Fed will need to maintain consumer confidence in the face of what is likely to be a rising unemployment rate. "This is a unique situation in which there has been a collapse in the demand for business-to-business services that the Fed can do little about," says Joel Prakken, a founder and principal at St. Louis-based economic consulting firm Macroeconomic Advisors.

Still, the increasing liquidity from previous rate cuts will come into play by giving consumers continued easy access to borrowing. But the psychological effect of the Fed's willingness to cut rates may prove as important as what actually happens at the next policymaking meeting on Oct. 2.


  Impatient economy-watchers seem to have forgotten that data proving monetary policy is working always lag several months. "Early in July, we saw initial unemployment insurance claims starting to drop because layoffs were abating," says Milton Ezrati, senior economist and strategist at Jersey City fund manager Lord, Abbett & Co, who adds: "But it wasn't clear it was a trend until a couple of months later."

Even when the data indicate it's working, monetary policy is no scalpel. "The Fed can lower interest rates and increase liquidity, affecting a broad swath of the economy, but it can't fix the tech wreck," says Ethan Harris, senior economist at Lehman Brothers. "That doesn't mean monetary policy doesn't work." Harris points to the comparatively strong sales of autos and housing, which have been financed by cheaper consumer borrowing, courtesy of the Fed's rate cuts. Mortgage rates began dropping in anticipation of the Fed's easing, and have come down 1.5 percentage points on average in the past 18 months.

Lower mortgage rates have had several positive effects on consumer spending. They led to a mini-boom in housing that caused real estate prices to increase 8% year-over-year as of August, 2001. Real estate prices are near their peaks for the current economic expansion. "The rise in housing prices helped to offset the drop in stock market wealth the past year," says Harvey Rosenblum, director of economic research at the Federal Reserve Bank of Dallas. That's a key factor when it comes to consumers' sense of well-being and confidence in the economy.


  With the values of their houses rising and the cost of debt dropping, many consumers refinanced their mortgages for a higher overall loan amount, albeit at a lower rate, and spent the difference. And that activity does not appear to be abating. "Year to date, refinancings have increased 459%," says John Lonski, chief economist at Moody's Investor Service. "In the two weeks ended Aug. 31, there was a noticeable increase in mortgage activity that ought to underpin consumer spending for the next couple quarters."

There's no guarantee, however, that the Fed's aggressive easing will trigger a roaring rebound when the economy does recover this time around. "The Fed has kept us out of recession, but anybody who thinks we're going to have a comeback that rivals the growth of the late '90s is out of their mind," says Rodney Johnson, president of Dallas-based H.S. Dent Investment Management. "There is no such thing as the Fed helping businesses sell to each other."

Yet a slow and sluggish recovery would hardly be a first. "In the recession of 1990 to 1991, there was overcapacity in commercial real estate that took years to clear up," points out the Dallas Fed's Rosenblum. "In 1993, the real estate market started to turn around a little bit nationally, but in Texas it took a little longer."


  The challenge the Fed faces is making sure that the consumer doesn't turn tail while the business sector rights itself, which is as much a delicate psychological task as a policy maneuver. On the downside, when the numbers are released Sept. 7, consumers are likely to hear that the nation's jobless rate rose to 4.6% from 4.5%. "The August numbers will reflect the earlier slowdown," says Lord Abbett's Ezrati. "The signs of an improvement won't appear in the employment report until the end of the year."

The Fed's task is to bolster confidence, which it has done as much as possible by letting it be known that the spate of rate cuts may not have ended -- a message, in other words, that Greenspan & Co. are still on the case. The ongoing low inflation allows central bankers to make that promise in a rather public way. "It's very important the Fed have enough transparency," says the Dallas Fed's Rosenblum. "It gives people the confidence that the Fed will do the right thing at the right time."

For the October meeting, that probably means another quarter point cut in the fed funds rate -- enough to shore up consumer confidence until businesses are back in the spending game.

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

Edited by Beth Belton