13th rate cut may be the economy’s charm

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Another interest-rate cut is all but certain from the Federal Open Market Committee at its June 24-25 meeting. It will be the 13th rate cut since the beginning of 2001, and it’s a needed 13th ounce of prevention. Here’s why.

First, there has been the recent furor over potential deflation. Though the risk of deflation has been characterized as “minor” or “remote,” it is much easier to combat deflation before it begins than once the vicious cycle is under way. Japan has been fighting a battle of futility against falling prices, a process that the Fed has been closely watching and is determined to avoid. Another interest-rate cut could be an antidote to the onset of deflation.

Does a 13th rate cut send a foreboding signal about the underlying health of the economy? Not exactly. Alan Greenspan has repeatedly stated that while the long-awaited economic expansion hasn’t taken place as soon or as strongly as hoped, we are drawing closer. A 13th rate cut is an effort to ensure that the second half of 2003 lives up to the economic projections that were originally assigned to the second half of 2002 but failed to materialize.

The Fed has already sent a not-so-subtle hint that it won’t be in a hurry to raise rates once a more vigorous economic expansion takes hold. This has given the green light to both bond and stock investors, with both markets uncharacteristically rallying together instead of the usual pattern of one market’s advance coming at the expense of the other.

Consumer confidence has been rising and consumer borrowing and spending has remained strong despite deteriorating labor market conditions. Employment is a lagging economic indicator, meaning the economy must improve before the employment outlook does. In the meantime, the Fed must keep everyone’s interest and attention until the headline act — a robust recovery — appears on stage.

Consumer confidence has been buoyed by the stock market rally since March, but with second-quarter corporate earnings season six weeks away, some profit-taking in the interim does seem inevitable. Conveniently enough, the jawboning that has pushed long-term interest rates lower has whipped homeowners into a refinancing frenzy, with borrowers lined up for loan closings as if someone was giving away money or at least giving it away at 46-year lows. The prospect of a 13th rate cut leaves that environment intact while an actual rate cut further saps any incentive to save by keeping short-term interest rates below the rate of inflation, and perhaps generating additional borrowing and spending by consumers and small-business owners alike.

Anyone who has had to stall hungry dinner guests until the main course is served can identify with the Federal Open Market Committee’s reluctance to sit back and wait for the economic engine to refire. A 13th rate cut is just another appetizer while we await the economic entree.

Greg McBride is a financial analyst for Bankrate.com.

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