Recent quarter-point rate cut proves caution is the name of the game when it comes to US economy
In the annals of Federal Reserve history, 1998 probably will be recorded as a year of great success for the nation's monetary policy.
Fed Chairman Alan Greenspan and his colleagues were credited with averting an international economic depression by cutting US interest rates. With Asia in crisis and Russia's meltdown troubling the globe in Autumn 1998, the Fed cut rates three times.
The success of the exercise won Greenspan a place on the cover of Time magazine as part of the 'Committee to Save the World.'' He also was a runner up for Time's person of the year honour.
With the benefit of hindsight, 1998 also can be remembered as a year when the Fed made one of its bigger policy mistakes. While equity investors who prospered from the bull market in stocks that resulted from the Fed's actions in 1998 may not agree, even some Fed staffers think that third rate cut was a mistake. The US roared ahead, asset values surged to record highs and the Fed had to raise rates in 1999 and 2000 to quell the euphoria.
The lessons from that experience provide insight into why the Federal Open Market Committee (FOMC) only cut a quarter-point from its overnight lending rate the other week, rather than a half-point. 'It seems that the FOMC has judged that it's those last couple that can bring on a headache the next morning, so it's best to take it slowly,'' says Rory Robertson, interest-rate strategist at Macquarie Bank.
Policymakers, especially the more hawkish ones, probably want to avoid executing rate cuts that they'll have to take back six months from now. It's possible that the economy will roar back in the second half of the year, thanks to the Fed's rate moves and the recently enacted $1.35 trillion tax cut. And the resulting volatility in interest rates could do even more harm to the economy.
Some officials feared as much as far back in May, when the Fed executed its fifth 50 basis-point cut of the year. A summary of the Fed May 15 FOMC shows that three members favoured slowing the pace of rate cuts. The reason was that a 1998-like rebound could ignite inflation. The fact energy prices have risen markedly this year only exacerbated such concerns. As recently as mid-May, policymakers 'suggested the Fed could be through cutting the funds rate soon,'' says Martin Mauro, a senior economist at Merrill Lynch.
It's also possible that the US will remain sluggish if businesses and consumers ' both weighed down by mountains of debt ' rein in spending. This concern explains why the central bank may cut rates again in August. Yet it's clearly nearing the end of its campaign to revitalise the economy. One of the clearest suggestions of this was the Fed's decision to incorporate a running total of its rate moves this year in the statement accompanying the recent rate cut. By mentioning they've gone 275 basis points so far this year, policymakers seemed to be saying 'we've done a lot already and now we want to see what happens.''
That gesture, however, coupled with the Fed's more modest 25 basis-point move, may end up being the most potent of all. This flies in the face of conventional wisdom. The bigger the Fed's move, economics textbooks tell us, the bigger the effect on the economy. By taking its most gradual step this year, the recent rate cut seemed to do more to buoy optimism on the economy than the others. The reason? The lack of panic at the central bank. Rather than talking up the economy, Fed officials put their rate policy where their gut feelings are.
Since January, the Greenspan Fed has been churning out crisp new US dollars with unprecedented enthusiasm. In the space of less than seven months, the central bank trimmed its benchmark overnight lending rate as aggressively as any Fed has in two decades. But by going just 25 basis points and saying little in its statement to suggest it's worried about a recession, the Fed provided an unexpected lift to Wall Street and, possibly, Main Street.
The effect was the mirror image of 1998, when the Fed's actions betrayed fear among monetary policymakers. Back then, the Fed's moves had an air of panic about them and everybody wondered what policymakers knew that the markets didn't. The recent cut, by contrast, communicated a sense that the central bank is on top of things and all is well in the world's biggest economy.
True or not, stock investors came away with that impression. Investors bought shares that have walked in place in recent weeks. The dollar also held up surprisingly well at a time when US short-term rates are sliding. And bonds are taking the Fed's hint that the economy may not be as weak as many analysts think. The yield on the 10-year note surged to 5.36% from 5.11% on the day before the Fed's rate cut.
The two-year note, the Treasury coupon that's most sensitive to overnight rates set by the Fed, jumped to 4.23% from 3.89%just three days before the rate move. Treasury yields are rising amid concern that the economy will shoot higher in the months ahead, boosting inflation and putting the Fed back into rate-increase mode. News that consumer spending, two-thirds of the economy, grew 3.4% in the first quarter, up from a 2.9% pace previously estimated, validated those concerns.
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