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Free money
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November 7, 2001: 7:21 p.m. ET
Interest rates are so low that borrowing is essentially free. And that’s good news.
By Michael Sivy
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NEW YORK (CNNmoney) - How low can interest rates go? On Tuesday, the Federal Reserve cut them for the tenth time this year, to levels not seen since 1961. Not too long ago, economists would have told you that a 2 percent federal funds rate was almost unthinkable. Consumer price inflation is currently running at a 2.6 percent annual rate, so after inflation, the cost of money entering the banking system is negative. Or to put it in simpler terms, banks can have money for free, as long as they're willing to lend it.
And there's an even bigger surprise - the rate-cutting isn't over. Based on the Fed's official comments on Tuesday, interest rates could be reduced again in December and January. We could be looking at a 1.5 percent fed funds rate before the recession is over. That's a level of short-term rates that you generally see only in Japan, where the 1989 stock market collapse ushered in an extended slump that is still going on.
That has some economists worrying that the Fed's aggressiveness is a sign of desperation and that the United States is slipping into a Japanese-style deflationary slump. In fact, exactly the opposite is true. The Fed's interest-rate policy is aimed at avoiding the problems that developed in Japan - and it will be successful.
Another Japan?
Japan's extraordinary slump developed for two reasons. First, the stock market and the real estate market crashed very close together. And the combined losses were so great that they wiped out much of the equity in the Japanese banking system. In the current U.S. downturn, by contrast, banking system losses are only a small fraction of total equity. U.S. banks will see their earnings suffer - but overall there is no threat to their net worth.
The other crucial factor is the level of interest rates. What matters to the economy is the level of inflation-adjusted interest rates, not nominal rates. Japan reduced its nominal rates so slowly that real rates never dropped substantially.
Fed Chairman Alan Greenspan recognizes that interest rates have to fall faster than inflation does to provide fuel for the economy. He also knows that he kept interest rates too high for too long last year. And, fortunately, he's willing to cut rates radically. Moreover, his policy is already showing signs of success. Although the economy is still sliding into recession, certain key indicators are already turning up.
Key indicators
The most positive sign, of course, is the behavior of the stock market itself. Prices are rebounding as though the lows were set in late September and a recovery is already under way. Barring another major terrorist incident, I think the economy will turn up in the first quarter of next year, as economists currently expect.
Another very bullish sign is the strength of productivity trends. The U.S. Labor Department reported on Wednesday that productivity rose at a 2.7 percent annual rate in third quarter, far higher than the 1.8 percent consensus estimate. Productivity normally deteriorates in a recession and improves in the first year or so of a recovery. The fact that it has held up so well in this slump means that earnings gains could be extremely strong once the next upturn begins.
Analysts are aware of this and will be quick to revise their earnings projections upward at the first sign of good news. In fact, that's exactly what has happened since Cisco reported a positive surprise on Monday. Although the networking company beat consensus estimates by only a couple of cents a share, analysts are jacking up their projected figures for he next couple of years. A string of upward earnings revisions would be extremely bullish for tech and also for companies sensitive to the level of interest rates and consumer spending, such as banks, brokers and retailers.
One of the most important side effects of the Fed's current rate cutting is the low in mortgage rates, which are now as little as 6.4 percent on a 30-year loan. Mortgage rates could go maybe another quarter-point lower, but basically this is the trough. And it will likely last into the first quarter of 2002. That should trigger another avalanche of mortgage refinancings as homeowners rush to beat the next upturn in rates.
Every household that refinances gets an average of $150 a month more to spend. Or they can take a bigger mortgage for the same monthly payment and spend the extra cash or use it to pay down credit-card debt. Either way, both businesses and consumers can look forward to an easier and more liquid economy early next year.
So don't worry that today's plunging interest rates are a sign of trouble - they're actually grounds for a sigh of relief.
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