Fed cuts rates half percent — will it work this time?

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The Fed has lowered interest rates by a half-percent today, cutting the key federal funds rate to its lowest point since Elvis Presley topped the charts with “Good Luck Charm.”

Even before Alan Greenspan and company fired their latest recession-fighting salvo, policymakers agreed that rate cuts alone won’t be enough to stop a stumbling economy from falling on its face.

The Federal Open Market Committee reduced the target federal funds rate to 2.5 percent. It had been 3 percent. The rate hasn’t been this low since May 1962, when Elvis was still king, Marilyn was still alive and John Glenn was still shaking ticker tape out of his trouser cuffs.

“The terrorist attacks have significantly heightened uncertainty in an economy that was already weak,” the committee explained. “Business and household spending as a consequence are being further damped.” The Fed’s statement went on to say that the long-term economic outlook is favorable but the short-term outlook isn’t. That means the Fed might cut rates again in the coming months.

The federal funds rate is the interest rate that banks charge one another for overnight loans. Other interest rates, such as the prime rate, are tied to it. The prime rate is expected to drop almost immediately to 5.5 percent. The last time the prime rate was this low was September 1972.

Short-term rates for some auto loans, adjustable-rate mortgages and credit cards will decline in the coming days and weeks. Rates for long-term mortgages are set independent of the prime rate, so it is tougher to predict whether they’ll go up or down.

Was it enough? Too much?
Everyone expected the Fed to cut the federal funds rate. The only disagreement was over the proper size. Some economists say they would have preferred a quarter-point rate cut, and the majority thought a half-point cut would work better.

Susan Hickok, chief economist with Prudential Insurance Co. of America, thought a quarter point would have been sufficient because, she says, the economy hasn’t yet registered the full benefit of the Fed’s rate cuts this year, and won’t until 2002.

But she thinks we’ll see an especially important benefit in the last three months of this year: Unlike most economists, she doesn’t believe we’re in a recession, and she thinks the economy will show small growth, but growth nonetheless, in the fourth quarter. She believes the Fed’s rate cuts in the first half of 2001 will end up preventing a recession in the last half of the year.

“I think a lot of stimulus has been put into the economy and is in the process of being put in the economy,” she says. She predicts that the economy will pick up in the first three months of 2002, and that inflation will pick up, peaking at above 3 percent.

The effect of this rate cut is largely psychological, “showing that the Fed is there,” Hickok says.

Hers is a minority view. Many economists believe that the Fed has done what it can, but tinkering with interest rates isn’t enough. These economists believe it’s time for Congress to get involved — to increase government spending as a way to stimulate the economy.

Fiscal policy, monetary policy
You’ll hear this talk a lot in the coming months. When economists and politicians mention monetary policy, they’re talking about the Federal Reserve influencing interest rates and the amount of money in the economy. When economists and politicians mention fiscal policy, they’re talking about government spending.

Right now, with unemployment rising and recession in the air, individual consumers are wary of spending. In times such as this, the government can spend more to keep the economy afloat. That’s what policymakers in Washington are talking about doing now.

Even Alan Greenspan has talked up government spending. He told Congress last week that if it passes a stimulus package, $100 billion of spending would be sufficient.

Greenspan’s testimony to Congress “suggests that monetary policy at some point becomes limited. It can only do so much,” says Kenneth Thomas, a lecturer in finance at the Wharton School of the University of Pennsylvania.

Thomas would prescribe more government spending as “Viagra to get the market up.” That kind of stimulus would work faster than the Fed’s interest rate cuts, he believes.

Thomas says that increased government spending, combined with tax rebates, will get the economy moving again, but at a price: a renewed deficit and, eventually, higher interest rates. “That’s kind of a secondary concern right now,” Thomas says. “Our biggest concern is getting the economy back on track.”

Loose credit, bad credit
Like most economists, Thomas believes the economy is in recession. He thinks the impetus was the election debacle at the end of 2000, which created a month of political and economic uncertainty. Thomas believes the recession will last until well into 2002.

He hopes that federal regulators don’t make a bad situation worse. More and more people are late on their credit card and mortgage payments, and bankruptcy legislation is on the way that will make life more miserable for people who are drowning in debt. Because of all the bad debt out there, regulators might be tempted to tell lenders to be careful about extending credit. That would be a mistake, Thomas says, because it could dry up the availability of credit — exactly the opposite of what the Fed is doing.

“What we want to avoid at all costs are comments from regulators that would be to the effect that we’re in a slowdown now, be careful with your credit underwriting,” Thomas says. “That type of activity can lead to an unintended credit crunch. That makes the situation even worse.”

Right now we’re awash in credit, and the Fed’s latest action makes credit even cheaper — at a time when more and more people are late with loan payments. More than half of the mortgage applications now are for refinancing, not home purchases. And according to the Commerce Department, people who got their tax refund checks in August didn’t buy stuff with the money — they saved it or paid down their credit cards.

In other words, even as the Fed lowers interest rates, Americans don’t seem all that eager to incur brand-new debt. That’s why you should get ready for the government to do the spending for us.

— Posted: Oct. 2, 2001