Ammo low, Fed eyes last bullet to lift economy
Federal Reserve's expected interest-rate cut this week may add modest stimulus but is not without risks.
For the past 2-1/2 years, the Federal Reserve has lowered interest rates to stimulate the economy.
The result has been a virtual gully washer of money in the economy. But now, as the Fed contemplates yet a 13h cut, it has become much more difficult and complicated to pump up the economy by lowering short-term interest rates.
So, when the Fed meets Tuesday and Wednesday to review the economy and make a decision on interest-rate policy, it will have to consider why this rainstorm of cash hasn't done the job.
If business won't build new factories at these low interest rates, will even lower rates make any difference? And, as interest rates get closer to zero, Fed chairman Alan Greenspan will have to ponder if he needs to keep some ammo in his pouch in case he needs it later this summer.
"The Fed's decisions are becoming increasingly difficult," says Jon Blumenfeld, US Interest Rate Strategist at Commerzbank Securities in New York.
Despite the difficulties, Fed-watchers expect Alan Greenspan and his fellow bankers will reduce rates yet again - probably by a quarter of a percent. But, a half a point is not out of the question.
In testimony Mr. Greenspan has talked about having an "insurance policy." He is worried about deflation; that is, prices falling much as they did in the Japanese economy. And, the stock and bond markets, which have been on a roll since March, are anticipating a drop in rates. Since the market rally began, stock prices have risen by almost $1.7 trillion.
"If the Fed did nothing, there could be a reversal in stock prices and bonds and that would affect the economy almost immediately," says Lyle Gramley, a former Fed governor, now a consulting economist at Schwab Washington Research.
But the stock market is not the Fed's only financial concern. For example, there is now $2.1 trillion invested in money market funds, places for conservative investors to store their cash. Any lower rates may put many of these funds in the red.
For example, in Baltimore, Jane Trust runs a Legg Mason money market fund. Her fund, which invests in tax-free securities, has a net yield for investors of only 0.30 percent. If the Fed drops interest rates, Legg Mason will have to begin to subsidize or waive part of its fees.
"We don't expect any sympathy," says Ms. Trust. But, she adds, "there is the issue of who will buy all the commercial paper [a form of short-term note] at yield levels that are not very enticing. Companies and municipalities have a need to issue that paper so at some point the low rates become counterproductive."
Fed observers also think it would be counterproductive for the Fed to use up all its ammunition. "You are very close to the limit of what you can do," says Mr. Blumenfeld. "You can't be perceived as having made your last move, that is very dangerous."
In fact, as the Fed looks at the economy this week, there are some encouraging signs. The president's tax cut has become law and should start to deliver some of that cash next month. Some business indicators point to better order rates. High tech spending is increasing. And, consumer spending is good.
"I'm hearing that things are stabilizing," says Sung Won Sohn, chief economist at Wells Fargo Banks in Minneapolis. "It's too soon to say it's improving."
Fed watchers, such as Mr. Sohn, want to see how the Fed words its interest-rate announcement. He thinks they may try to move away from deflation and focus more on economic growth. "I'm not sure if they are happy with this deflation psychology," he says.
If the Fed opts to cut rates, some economists argue the Fed may be running a slight risk of overstimulating the economy. For example, the housing market is already hot as Americans take advantage of low mortgage rates. Last week, mortgage rates once more hit a low with some banks offering 30-year fixed rate mortgages as low as 4.99 percent. There is talk about housing becoming a dangerous bubble.
"How much more stimulus can we take?" asks Sohn. However, Mr. Gramley believes the Fed has plenty of leeway to act. "If they do too little and we see outright deflation, then it gets pretty dicey," he says. "But, if they do too much, they can always correct later."
The Fed's heard these arguments before - probably right before its last meeting on May 6. Since then, long-term interest rates have fallen about half a percent, reflecting the weak economy. The tax cut has been signed into law. And the stock market rally has continued. "Those events are enough to offer encouragement," says Gramley. "But, so far we only have a forecast of improvement; we haven't actually seen any."