News > Economy
Do rate cuts still work?
October 3, 2001: 2:27 p.m. ET

Some worry the Fed has used up all its ammunition in the war on recession
By Staff Writer Mark Gongloff
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NEW YORK (CNNfn) - What if the Federal Reserve cut interest rates and nobody cared?

That's a question being asked with increasing frequency these days after the Fed's ninth cut of the year Tuesday, which took the central bank's target for a key overnight bank lending rate to a level not seen since John Kennedy was president.

Some analysts have begun to use the word "Japan" for comparison when discussing the U.S. economy, which can't be good for already wobbly consumer confidence.

In Japan, the world's second-largest economy, key interest rates are near zero, but the economy is marching grimly into another recession, or what Princeton economist and New York Times columnist Paul Krugman has called a "slow-motion depression."

The biggest worry for most economists is that the rate cuts won't do enough to encourage American consumers to pick up their spending again now that their confidence has been hurt by the Sept. 11 attacks that destroyed the World Trade Center in New York and damaged the Pentagon outside Washington.

"If people are depressed and scared, as they have been in Japan, there are limits to monetary policy," said Warren Bailey, finance professor at Cornell University's Johnson School. "It comes down to people making personal decisions."

Another problem for the United States is still sluggish business spending, the primary contributor to an economic slowdown that has lasted longer than a year.

Companies simply spent too much money on new technology and equipment back in the good old days of the 1990s. When demand for new products dried up after the Nasdaq bubble burst and the Fed raised interest rates in 1999 and 2000, manufacturers stopped making new goods until their backlog could be sold off.

With a bunch of shiny, new equipment sitting around doing nothing -- what the Fed calls low "capacity utilization" -- no amount of cheap credit is going to persuade companies to borrow to buy more equipment until they know somebody is going to buy what they make.

"Lower interest rates aren't going to make anybody go out and buy new capital equipment right away," said Scott Brown, chief economist at Raymond James & Associates. "And a lot of businesses are sort of frozen because of the attacks."

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In the past, rate cuts could be counted on at least to give an immediate boost to stock prices, and Tuesday's cut seems to have lifted the Dow, Nasdaq and S&P 500. But those major stock market gauges were down sharply this year even before the attacks as investors for the most part ignored the Fed's seven rate cuts before Sept. 11, focusing instead on corporate earnings, which were withering as the economy slowed to a crawl.

President Bush discussing his plans for the economy
"Low visibility," a euphemism for companies' inability to predict future profits, was a popular catch phrase before the attacks. Now, as America gears itself up for a fuzzily defined war on terrorism, visibility is even poorer.

"For businesses, the natural reaction to more uncertainty is to put off major projects or investment of any sort," said Henry Willmore, chief economist at Barclays Capital, who added that the uncertainty after the terror attacks "will continue for a period of weeks or months, significantly longer than after natural disasters."

In such an environment, many think the only real help for consumer and investor sentiment is going to come from Congress, in the form of a tax cut or other stimulus that puts money directly in the consumer's pocket.

"The best way to stimulate demand is to give people some money so they can spend it," President Bush said Tuesday morning, bluntly belittling the power of the Fed cut that came later that day. Bush Wednesday proposed a fiscal stimulus package of between $60 billion and $75 billion, on top of the $55 billion the government already has spent since the attacks.

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But Fed policy has worked in at least one traditional way, by holding up the housing market with dirt-cheap interest rates.

Rates are also now approaching the rate of inflation. They're already below the Labor Department's Consumer Price Index, the government's main inflation gauge, now at 2.7 percent; and as rates fall below inflation, people could be discouraged from saving their money and instead choose to put it back into the economy.

"It reduces the rate of return on that $6.5 trillion hiding in money-market accounts," former Fed governor Wayne Angell, now Bear Stearns' chief economist, told CNNfn's Market Call program. "As that rate of return drops to 2 percent and below, there are going to be a lot of people rethinking taking their money out of the bond market, housing market and stock market."

It's also possible that many observers are simply being impatient; Fed rate cuts often take several months to have an impact on the economy, and it's impossible to tell how long they actually will take this time.

"Imagine you stay in cheap hotels where the hot water doesn't work in the shower and you have to fiddle with the knobs to fix it," said Cornell's Bailey. "Sometimes it's too hot, sometimes it's too cold. And imagine you don't stay in the same hotel twice. That's the problem we face with monetary policy. It's crude, it's a fuzzy instrument and it's applied in a different circumstance every time."

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Some analysts think the Fed's earlier rate cuts may already be working, that the economy would probably be in much worse shape if the Fed hadn't acted aggressively this year.

"On Sept. 10, there was a strong chance we'd dodge a recession as historically defined," said Kevin Hassett, an economist formerly with the Fed and now with the American Enterprise Institute. "One reason we had dodged a recession was remarkably timely Fed policy. Fed policy has as much chance to work as it ever has."

In fact, it could possibly work too well, if people worry that all the stimulus swamping the economy next year will spur inflation. Inflation fear pushes long-term interest rates up, discouraging borrowing. So far, though, inflation hasn't been a concern for the Fed, and soothing comments by Bush and Fed Chairman Alan Greenspan have helped keep long-term rates in check.

Fundamental differences between the United States and Japan also mean the two nations' economies aren't likely to follow the same path. A more responsive and creative central bank and a more effective tax policy are some of the advantages analysts have mentioned the United States has over its rival.

"If you look at the fundamentals of our economy -- is it mean, lean and flexible, does it have right ideas about how to produce -- all the good stuff is there," Cornell's Bailey said. graphic


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