The deluded investors and analysts who were counting on the Fed to lower its target for short-term interest rates by three-quarters of a percentage point—or even a full point—certainly were disappointed by the half-percentage-point drop announced Tuesday afternoon.
But for anyone who has followed past actions of the Federal Open Market Committee and recent speeches by some its voting members, the 50 basis point cut was quite predictable.
Yes, the real economy, particularly manufacturing, continues to slow. Consumer sentiment is less optimistic than in the past. And nearly everyone believes that the reverse “wealth effect” of falling stock prices will damp consumption at least a bit.
But if one looks at employment numbers, unemployment rates, consumer spending and construction, the U.S. economy is farm from dead. The committee acted to stimulate the fundamental real economy of the nation. But it stiffed those investors yearning for the Fed to keep the value of their portfolios from eroding further.
Let’s look at what happened. The Fed’s actions are straightforward. It lowered its target for the federal funds rate by 50 basis points, or one-half of one percentage point, to a new level of 5 percent.
The Fed also approved the requests of all 12 district banks to lower the discount rate to 4 ½ percent. (The discount rate is what the Fed charges when it loans to banks.)
While this measure is largely symbolic, it’s highly unusual for all 12 banks to request a discount rate cut at the same time. Usually there is enough variation in economic strength or weakness between districts that discount rate changes are made at the request of seven to nine banks, not all 12.
Tuesday’s unanimity indicates that the economy slowed across the 50 states, and that there are no anti-inflation hawks holding out against easier money. It also means that the presidents and the boards of directors of each district banks, from Boston to San Francisco, agree that monetary policy should be loosened somewhat.
But why was the fed funds target cut one-half of one percentage point, not three-quarters of a point as many expected? There is no mention of this in the news release. The minutes of the meeting, which will be made public in a couple of months, may shed a little light on this.
I can only speculate, but the committee most likely was split. One or more members favored a ¾-point cut or more to send a strong signal that the Fed would provide liquidity to keep the economy from slowing further.
But I am also sure that some other members did not want to fall into the trap of making a move to shore up the stock markets. Most committee members are wary of the Fed stepping into that role. Better to announce a smaller-than-hoped-for loosening rather than contribute to another bout of irrational exuberance.
That raises the question of whether the committee considered stock market conditions at all.
In three paragraphs of explanation of its action, the committee included only one five-word clause with an oblique reference to the markets: “Persistent pressures on profit margins are restraining investment spending and, through declines in equity wealth, consumption.” In other words market declines matter only to the extent that the reverse “wealth effect” cuts demand for goods and services in the real economy.
What about sluggishness in Germany, the still teetering Japanese economy, and severe problems in Turkey, Argentina, Brazil and Indonesia?
This factor merited greater explanation than stock markets: “The potential for weakness in global economic conditions suggest substantial risks that demand and production could remain soft.” In other words, the international situation is a serious matter.
There was hardly a hint of the Fed’s next move. Nearly everyone was caught off-guard when the FOMC cut rates on January 3 after a telephone conference call meeting. Might that happen again?
The statement holds out an ambiguous reassurance. “In these circumstances, when the economic situation could be evolving rapidly, the Federal Reserve will need to monitor developments closely.”
I’d read that as, “If something really major happens, we may act before the next scheduled meeting on May 15. But don’t count on it.”
The committee also announced a “bias” signaling the direction of possible future action? It said that “the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.” No news here, in fact it would merit screaming headlines if this statement had been omitted.
It is far too early to tell what Tuesday’s actions will accomplish. Remember that a full year often must pass before anyone can discern the true effects of monetary policy changes on the real economy. But don’t count on this action to send the Nasdaq, Dow or Nikkei back up.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.