Investors are counting on the Federal Reserve to cut short-term interest rates, whether or not a reduction is needed.
On Wednesday, the Fed’s rate-setting Open Market Committee is expected to cut the federal funds rate, which has stood at 1.25 percent since November.
Stock prices have a rate cut built into them. That would make it risky for the Fed to leave rates alone, economists say, because such a non-move would drive down stock prices.
The Chicago Board of Trade has priced in a 100-percent probability that the Fed will reduce the federal funds rate by at least a quarter of a percentage point. On Thursday afternoon, the Board of Trade was pricing in a 30- percent probability that the Fed would cut the overnight rate by half a point. Traders set these odds by buying and selling “fed funds futures.”
The federal funds rate is also called the overnight rate because it’s what member banks charge one another for overnight loans. Other interest rates, most notably the prime rate, move in lockstep with the overnight rate, which ultimately affects the rates that consumers pay on some credit cards, auto loans and equity loans.
The overnight rate is at its lowest point since the 1950s. The Fed has cut the rate 12 times since January 2001. That and subsequent reductions didn’t avert a recession, which started in March 2001, but the rate cuts ensured that the downturn was shallow. Nevertheless, the economy struggles to extricate itself from the economic recession, like Bigfoot crawling out of a tar pit.
After a dozen rate cuts, will the 13th time be the charm?
“I’m not sure it’s going to do much good for the economy, if it’s going to make that much difference,” says Philip Russel, assistant professor of finance at Philadelphia University. “They’ve already cut interest rates quite a bit.”
Typically, the Fed cuts short-term rates to stimulate the economy. When rates are low, consumers are more likely to borrow money to buy things. Low rates stimulate businesses from two directions: rising consumer demand on one side, and cheap money on the other. So, low rates encourage businesses to invest in new plants and equipment, further stimulating the economy.
This long round of cuts in the overnight rate, from 6.5 percent at the beginning of 2001 to 1.25 percent now, has exerted the desired effect on consumer spending. Some homeowners have refinanced multiple times, and many people are driving cars that were bought with zero-percent interest loans. But businesses have stubbornly remained reluctant to hire new employees, buy equipment or build plants. Last week, 421,000 people filed for unemployment insurance.
“I don’t think businesses are ready to make investments,” Russel says. “No matter how much money you give them, they’re not going to go out and start spending.”
Most economists and investors agree with that assessment.
There’s another, more compelling case for cutting short-term interest rates: to smother deflation before it has a chance to draw its first breath.
After its most recent meeting, in early May, the Open Market Committee said, “the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.”
The Fed was saying that it didn’t believe the economy was likely to fall into a deflationary spiral of falling prices and rising unemployment, but it was going to make sure such a scenario didn’t happen, even if it meant an inflationary spike later. Observers deemed this a wise and shrewd move. If there’s anything worse than high inflation, it’s deflation, which is much harder to fight. Anyway, the Fed has plenty of experience fighting inflation, and not much experience battling deflation.
After that Fed announcement, members of the rate-setting committee made it clear that they meant what they said. Investors believe that “the Fed has given a virtually ironclad promise to stave off nascent deflationary pressures,” in the words of Wayne Ayers, chief economist for FleetBoston Financial. “But perhaps even more important than the size and timing of the next cut in rates is the realization that the Fed now intends to keep rates at or below current levels for a very long time and will not reverse course even as the economy starts to show convincing signs of a sustained pickup.”
David Seiders, chief economist for the National Association of Home Builders, gives the most pragmatic reason for believing that the Fed will cut short-term rates: to keep from spooking the markets. Everything from stocks to mortgages are priced on the assumption that the Fed will cut.
“At this point, the Fed must cut the short-term rate in order to preserve the decline in long-term rates achieved through its public pronouncements,” Seiders writes in his weekly economic commentary.
Kenneth Thomas, a lecturer in finance at the Wharton School of Business, believes the Fed will cut the overnight rate by one-quarter of a point, for several reasons. For one, cutting the rate to 0.75 percent could cause some turmoil in money market funds because some funds’ expense ratios would exceed their yields.
Further, Thomas says, “When you take the rate below 1 percent, it’s almost a sign of too much concern.”
And a reduction by one-quarter point, to 1 percent, would leave the Fed with four more quarter-point “bullets,” Thomas says. “To use two of them in one shot — I don’t think that would be the best thing right now.”