The Case for the Fed

Although some investors have carped that it did not do enough, the Fed's rate reductions have kept the economy afloat

By Joseph Lisanti

On Aug. 12, the Federal Open Market Committee announced that it would maintain the fed funds rate (what banks charge each other for overnight loans) at 1%. More important, the Fed indicated that it would keep short-term interest rates low to help sustain the nascent economic recovery. The market greeted the news with a rally that day.

Alan Greenspan and his colleagues have been trimming the fed funds rate since January 2001. In a surprise move, they lowered it from 6.5% to 6% on January 3rd of that year. The market promptly rose 5% on the day of the announcement.

Despite that auspicious start, stocks have generally trended lower throughout the cycle of easing that began in early 2001. Does that mean the Federal Reserve has been ineffectual?

Not really. If the Fed hadn't lowered short-term rates, things might have been much worse. Consider that consumer spending, which has sustained the economy for the last three years, would have been anemic were it not for the influx of household cash that came from all those mortgage refinancings. Mortgage rates would have stayed high if the Fed had not acted. And don't forget auto sales prompted by zero percent financing-thanks again to the Fed's efforts.

Contrast the Federal Reserve's recent actions with what happened in the Great Depression. Then, the Fed, worried that the speculation of the late 1920s would reappear, maintained a tight monetary policy throughout 1930 even though a recession was already underway.

The stock market began its upturn last year at a point when the fed funds rate had been unchanged for many months. Although the previous rate reductions had supported the economy through its weakest periods, what got the market going again was the perception that some of the excesses caused by the speculation of the late 1990s were finally being worked off.

We continue to advise keeping 60% of investment assets in equities.

Lisanti is editor of Standard & Poor's weekly investing newsletter, The Outlook

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