Commentary: The Case Against a Rate Cut Now

During the U.S. economy's slide into recession and more recently, as confidence has been battered by corporate scandals and swooning stocks, Alan Greenspan has been a voice of calm amid the chaos. But now, the Federal Reserve chairman finds himself in a touchy spot: With fears of a double-dip recession growing, he's being urged to back up his soothing sermons and give the economy a jolt by cutting rates again.

The loudest cries for lower interest rates come from Wall Street, where fears are rampant that the expansion is losing steam. That view was bolstered by a jarring July employment report that showed virtually no job growth, with both services and manufacturing stalling. Soon afterward, analysts at Goldman Sachs predicted that the federal funds rate might dip to as low as 1% by the end of the year. Currently, the funds rate sits at 1.75%, the lowest in 41 years.

Goldman is hardly alone. Indeed, with most big banks predicting a cut, traders in the fed funds market are now betting that rates will fall to nearly 1.5% by January And the growing view that further rate cuts are likely sent stocks soaring on Aug. 6. "Weakness in the equity market has been significant, and the economic numbers have been poor," says Goldman senior economist Jan Hatzius. "The Fed has to respond."

But does it? Greenspan dislikes being pushed into a move by Wall Street. And he's well aware that markets often overshoot on the downside. Indeed, some of the same firms now forecasting rate cuts were calling for higher rates last spring.

But fundamentally for Greenspan and his Fed colleagues, the problem is this: They're not sure today's bout of investor angst warrants an opening of the monetary spigots. While growth is likely to be slower than expected in the second half, Greenspan & Co. still doesn't expect a double dip. While a cut now might help psychologically, it may not be supported by the fundamentals--especially since housing and consumer spending are still holding up.

To the "cut now" crowd, the case for ease is compelling: Manufacturing's rebound has lost some of its zing. The service sector has been slow to perk up. A broad-based comeback in corporate profits looks elusive. And with no inflation on the horizon, the Fed appears to have the room it needs to trim rates. "Greenspan always said the Fed doesn't respond to financial markets; it responds to economic events," says Steve Slifer, co-chief U.S. economist at Lehman Brothers. "Well, [the recent spate of bad economic data are] a real-live economic event."

So why not cut and be done with it? Greenspan believes the nature of the 2001 slump dictates caution. While the economy contracted over three quarters starting in early '01, the recession was only glancing. That means the bounceback will be just as slight, without the surge that follows a deeper slump. Bottom line: a slow profits rebound and a poky recovery, but a recovery nonetheless. To some Fed officials, that's not a scenario for more ease.

Then there's the issue of the Fed's depleted ammo. The central bank has cut rates 11 times and by 475 basis points since January, 2001. At this point, Greenspan must time additional cuts carefully. He must save them for when they're most needed rather than shooting bullets at phantoms.

None of this means that giddy optimism reigns at the Fed. The stock market bust wiped out an estimated $6 trillion in equity since the market's peak in March, 2000. While a post-boom bloodletting is a precursor to a healthy rebound, officials admit the shock has reduced the economy's buffer zone and bears close watching.

Even if the Fed decides to follow the market's lead and signal at its Aug. 13 meeting a bias toward lowering rates later, Greenspan will still have to tread carefully. Thanks to Queen Elizabeth, he will soon be knighted. But with econo-jitters rising and the Fed looking a tad behind the curve to some, Sir Alan could soon be dodging lances from all sides.

By Laura Cohn

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