One More Cut, Please, Mr. Greenspan
By Christopher Farrell
I need another car, and soon. My 1995 Plymouth Voyager is beat up and falling apart. The heater barely functions, a significant drawback during Minnesota's long winters. The summer months are uncomfortable, too, since the broken air-conditioning system isn't repairable.
So, last weekend I was determined to buy a well-maintained used car I had picked out -- with lots of upgrades at a reasonable price. But after February's stunning job loss of 308,000 and increasing signs of a war with Iraq, now just didn't seem like a good time to take on more debt. I canceled my meeting with the car dealer. Multiply this anecdote by the hundreds of thousands nationwide and you know why the U.S. feels like it has skidded to a halt.
The flagging economy has convinced half the Wall Street community that the Federal Reserve Board will cut its benchmark interest rate by a quarter point at its meeting scheduled for Mar. 18. But others are skeptical that the Fed will ease, among them James Paulson, chief investment officer at Wells Capital Management.
Paulson points out that even though consumer and business confidence is evaporating, the underlying economic fundamentals remain positive. For instance, disposable consumer income, corporate profits, industrial production, and inflation-adjusted capital spending on equipment and software are all up year-over-year.
It's true that commodity prices, excluding oil and gold, are rising, a traditional harbinger of stronger economic activity. Demand from China's manufacturing machine is tightening markets for iron ore, nickel, and aluminum. Paulson adds that the Fed may first want to see how the potential war with Iraq goes. The central bank has a strong incentive to keep its powder dry until it's clear whether war, if it happens, will be quick and easy, or long and messy.
Still, I believe in this instance the Fed should ease again, perhaps by a quarter point. With job losses mounting and confidence plummeting, the odds are high that the economy is sliding back into recession. The risk of a downward deflationary spiral in the U.S. is simply too great for Greenspan & Co. to stay on the sidelines. Already, broad price indexes are falling throughout much of the world economy. That could spread to the U.S. The prospect that our nation could slip into a Japan-like, decade-long deflationary decline is a danger too great to ignore.
War is always dangerous, and in many cases lethal, for soldiers and civilians in the combat zone. And no matter what the textbooks teach, war is bad for business and confidence on the home front. Nerves are fraying, with President Bush flailing around for international support while domestic discord increases. With the duration and extent of any battle unknown -- as well as the magnitude of any casualty list -- managers in executive suites, workers on factory floors, traders on Wall Street, and consumers at home are caught in a state of semi-paralysis.
Adding to everyone's fiscal and emotional stress is the huge run-up in oil prices, with gasoline selling for more than $2 a gallon in many parts of the country. The giant auto industry is foundering, with car and light truck sales down 4.6% so far in 2003. Mar. 13's rally notwithstanding, the three-year-long bear market just won't quit, with the stock market down almost 9% so far this year.
The budget crisis in states too numerous to mention has gone from bad to worse. State and local spending cuts and tax hikes are a drag on the economy. Is it any surprise that the National Bureau of Economic Research, the official arbiter of the American business cycle, can't decide whether the 2001 recession truly ended?
The Fed is the sole remaining public-policy lever to prop up the economy. The Bush Administration's fiscal policy is a political disaster and an economic hodgepodge. The Administration is embracing massive deficits for years to come, while coyly refusing to even estimate the fiscal consequences of regime change in Iraq.
What Bush & Co. doesn't want to admit is that once the immediate crisis is over, investors will hardly race to embrace Treasury bonds when the federal budget deficit is 3% to 4% of gross domestic product, vs. 2% of GDP today. "The resulting higher long-term interest rates would wash out the economic benefits of further tax cuts and/or spending increases," says Mark Zandi, chief economist at Economy.com, the economic consulting firm.
Of course, just one and a quarter point remains between the central bank's key short-term rate (the fed-funds rate) and zero. And yes, the Fed's conventional technique for stimulating the economy struggles to be effective once the fed-funds rate hit zero. Just ask Japan's ineffectual central bankers if you're skeptical.
Yet the Fed has gone out of its way in recent months to emphasize that it has several other options to quicken the economy's pace, including buying long-term Treasury securities and announcing yield ceilings on longer-term debt. Now no one wants to find out whether those techniques will work. The Fed had better ease -- and then cross its fingers.
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online
Edited by Beth Belton