Wall Street threatens Fed with fit
Wall Street expects the Federal Reserve to cut interest rates again tomorrow.
And if it doesn't, many economists say the results won't be pretty.
"The stock market will take a serious dive," says Gordon Richards, chief economist of the National Association of Manufacturers in Washington.
Many investors assume the Fed is ready to trim short-term rates another 0.25 percentage point, on top of the two previous cuts Sept. 29 and Oct. 15 of the same size.
And when he spoke to a securities industry group two weeks, Fed chief Alan Greenspan seemed to indicate as much.
"There has been a sigh of relief across investment classes since the second of these rapid-fire Fed moves," notes Robert DiClemente, a New York economist with Salomon Smith Barney, an investment firm. "I don't think it would be wise [for the Fed] to retreat."
He sees the risks from being too easy with monetary policy as less than those of staying put.
Investors have already pushed up stock prices on the assumption of a rate cut.
The Standard & Poor's 500 stock index has risen about 17 percent in the past month.
In effect, Wall Street is telling Mother Fed it will throw a fit if it doesn't get its way on interest rates.
"The risk of global credit crunch would rise," holds Richard Hokenson, an economist at Donaldson, Lufkin & Jenrette, an investment firm in New York.
Mr. Hokenson worries that the "dash for cash" could return. Investors might again retreat to the quality of Treasury bonds, causing interest rate spreads between risky and nonrisky investments to widen again. Companies would have trouble once more raising money through bond issues or initial public offerings of stock.
It was that trend which caused Mr. Greenspan to cut rates unexpectedly in October.
"We would become much less sanguine about the prospects for economic growth next year," Hokenson adds.
No rate cut would produce a chain reaction, economists say. With interest rates unchanged, the US dollar would strengthen on foreign exchange markets. That's because international investors prefer higher rather than lower returns on investments in dollar-denominated assets.
The counterpart of a stronger dollar will be a weaker yen. Japanese banks own a lot of dollar-denominated loans that they count as part of their assets. The yen amount of those loans thus increases. This then reduces the banks' ratio of capital to assets. And that leads to further reductions in lending in Japan, extending its recession, hitting the world economy.
A bit complicated, but that's one danger seen by Hokenson. Another is that a weaker yen would revive the prospect China might devalue its currency. And that would imperil other currencies in Asia and in Latin America. Bad news.
Mr. Richards's economic daisy chain goes like this: Lower stock prices undercut the wealth of investors. Feeling poorer, they spend less. Companies, faced with weaker demand for their goods and services, will lay off employees.
Profits would decline as well. With the Fed keeping interest rates steady, the cost of servicing business debts would not fall. So stock valuations, already expensive, would become even more so.
Richards also sees inaction as raising the risk of a crisis in Latin America.
One problem for the Fed is that when it pumps money into the economy to lower interest rates, some of that money could flow into stocks and create a price bubble - like that which hurt Japan badly.
But Mr. DiClemente sees that as a small risk. Investors, he says, have been chastened by the stock drop this summer. "Stocks are below their old highs," he says. And the economy is weakening.