Steady as she goes
Gerard Baker, Financial Times, April 26 2001

To the optimists, last week’s surprise half-point rate cut by the Federal Reserve was a perfectly timed move that finally lit the fire of recovery under the sputtering US economy.

The reduction in the key short-term interest rate, the federal funds rate, to 4.5 per cent, was delivered at an inflection point in the economy’s fortunes. It provided critical support for a stock market that had begun to edge back from its trough last month and restored Alan Greenspan, the Fed chairman, to his economic pedestal.

To the pessimists, it was an act of desperation: an extremely rare second half-point rate cut between scheduled meetings of the Fed’s policymaking open market committee, reflecting just how weak the US economy has become. It brought the central bank’s emergency monetary easing to 2 percentage points in little more than a hundred days - cause for alarm at the way in which the economy has spiralled out of the Fed’s control.

But to the Fed itself it was neither. The decision to lower rates last week was taken in fact at the previous FOMC gathering on March 20. At that meeting the Fed’s policymakers appeared to ignore market pleas for a 75 or even 100 basis point cut and opted instead for 50. But, in a decision that was signalled in the committee’s statement accompanying the rate cut, the FOMC agreed to cut again some time near the middle of the period between meetings. Since the next meeting was on May 15, the midway point was April 15-16 - when the Fed made its move.

In the Fed’s view, its actions this year reflect a judgment made when the economy began to deteriorate at the turn of the year. The central bank then faced growing evidence of a sharp fall in capital spending, declining profits and sliding business and consumer confidence. Policymakers decided that unless there was a sudden upturn in the economy’s fortunes, they would need to cut rates substantially, over a period of many months, to a level consistent with recovery.

On this view, the neatly spaced cuts represent a steady progression towards the Fed’s ultimate destination. But what is that destination? How much lower is the Fed planning to cut rates in the absence of compelling evidence of economic recovery?

One of the main tools used by Fed officials to gauge the appropriate policy stance is an assessment of a neutral - or equilibrium - real rate for federal funds. This is the inflation-adjusted level of interest rates that provides neither a monetary squeeze nor a stimulus. When the economy is expanding above its estimated long-term potential rate of growth, the real fed funds rate needs to be above the equilibrium and vice versa.

Economists at the Fed believe the equilibrium rate has risen in the past few years as a result of the acceleration in the economy’s growth rate of productivity and is probably between 2.25 and 2.75 per cent. With current inflation at about 2.5 per cent, that suggests the nominal equilibrium rate is about 4.75 to 5.25 per cent.

The Fed’s move last week brought the fed funds rate to 4.5 per cent - below the neutral rate for the first time in several years. But since the economy is clearly growing below potential, the indications are that the rate needs to go lower still. That points strongly to another cut by the Fed at its May 15 meeting and probably further to follow.

The only thing that is likely to stop the Fed from moving further is confidence that the economic conditions in place since the end of last year have changed substantially for the better. And despite some optimism in financial markets that the turn may have come, Mr Greenspan and his colleagues do not appear to think they have seen it yet.

In assessing the outlook, the Fed seems to be weighing one strong probability and two uncertainties.

The strong probability - and the main threat to the economy - is a continuing fall in capital investment. The surge of the past 10 years was the catalyst for the rapid growth America has enjoyed in the past five. The reversal of this growth in the past six months is the main reason for the economy’s woes.

In the first three months of this year, investment in non-defence capital goods dropped by 3.3 per cent on the last quarter of 2000, as companies faced a glut of expensive new technology they could not put to productive use. Industrial capacity utilization, according to the Fed, is below 80 per cent - its lowest level in eight years - a worrying indication that further retrenchment is likely. The anecdotal evidence from companies strongly suggests that they plan to continue cutting overcapacity - and so net investment - for some time.

The problem for the Fed is that this classic investment-cycle bust seriously limits the effectiveness of monetary policy. When companies are in the process of unwinding over-investment, rate cuts are, as John Maynard Keynes put it, like pushing on a string. The one hope is that the technological innovations of the past few years may have improved information available to companies and shortened the lead times of capital stock adjustment. But nobody at the Fed seems to be betting on it.

What the Fed can do is mitigate the broader economic consequences of the investment bust. Here it faces its two uncertainties. The principal one is over consumer behavior. Consumer spending has been flat in the past two months and Fed policymakers think that what happens over the next year or so depends on how Americans view their wealth. This will determine the judgment they make about the need to rebuild their savings.

The personal savings rate has slipped gradually over the past six years to zero - or just below - as consumers have calculated that the growth in their wealth satisfies their long-term savings needs. The household wealth-to-income ratio has risen to more than five in the past few years from a recent trend of a little over three. This growth in household wealth has come both from the run-up in equity prices and a steep rise in house prices.

Usually these two contributors to wealth move in lockstep. But in the past year, they have diverged as equity prices have fallen sharply while house prices have continued to rise. Fed economists are looking closely at which of these two variables has the bigger influence on consumers’ assessments of their spending and saving needs. If the housing market remains strong - and new figures on Wednesday suggest it does - that might bolster consumer spending. But if it does not - or if it seems that consumers are more concerned about falls in equity prices - they are likely to retrench further in the next year or so. That would raise the personal savings rate to more normal historical levels and reduce spending, with damaging implications for the economy.

The second uncertainty is in the international outlook. For the past five years the US has been the principal engine of global growth. But with growth this year expected to be about 1.5 per cent, it is now the US that needs strong expansion elsewhere. This would help its exporters offset some of the domestic weakness and reduce the US current account deficit. The latter currently runs at about 4 per cent of gross domestic product, which constantly threatens the dollar’s strength.

But Japan is in recession, with a threat of worse to come. Meanwhile Europe, for all the confidence of central bank officials that they can avoid the worst effects of the US slowdown, is unlikely to remain immune. Without stronger growth in Europe, the US and the world face both weak economic conditions and current account imbalances among the world’s main economic blocs. This could have a destabilizing effect on the world economy.

This backdrop of declining capital investment, a risk of a sharp consumer retrenchment, and deteriorating conditions overseas is not conducive to optimism. The signals from the Fed’s policymakers are that it does not regard its work as over yet - not by a long way.

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