Amid a Wall Street clamor for bolder action to stimulate a sluggish economy, the Federal Reserve opted for a more moderate course Tuesday and reduced short-term interest rates by a half percentage point for the third time this year.
Yet the nation’s central bank, headed by Chairman Alan Greenspan, sent a strong signal it is prepared to slice interest rates again to combat what it saw as “substantial risks” in the form of weak sales and production, as well as the prospect of a worldwide slowdown.
“In these circumstances, when the economic situation could be evolving rapidly, the Federal Reserve will need to monitor developments closely,” the Fed said in a statement. Analysts take these words as signaling another possible interest rate cut well before the next Fed meeting on May 15.
But far from being soothed, Wall Street reacted with fury, knocking down the Dow Jones industrial average 238.35 points to close at 9,720.76, its lowest level in two years. The Nasdaq fell 93.74 to close at 1,857.44, its lowest since November 1998.
“We’re disappointed. We thought they would reduce rates by three-quarters of 1 percent,” said Stan Shipley, economist for Merrill Lynch in New York. He predicted Greenspan’s Fed would cut interest rates by another half point before May 1.
Many Wall Street analysts believe the Fed chairman has been too cautious in reacting to the decline in equity prices–a decline they blame him for engineering with the slowdown that followed when interest rates were raised in 1999 and 2000.
As they see it, Americans who have seen the value of their portfolios plummet are now less inclined to spend than they were a year ago, a fact that can only be changed with an aggressive interest rate policy that will make this slowdown a brief and shallow one. The prospect of higher energy prices and economic troubles in Japan also add to the tension, they say.
Even so, Fed policymakers resisted pressure for a bigger cut.
“Greenspan and his band have thumbed their nose at Wall Street,” said former Labor Secretary Robert Reich, now an economics professor at Brandeis University. “It’s a dangerous policy. … Consumer confidence could plummet very quickly if people begin to be concerned about their 401(k)s and the security of their jobs. We’re on the knife’s edge here.”
The central bank made clear its concerns about a possible recession, saying its monetary policy was tilted toward treating “conditions that may generate economic weakness in the near future.”
After its meeting, the Fed’s policymaking arm, the Federal Open Market Committee, announced it would reduce its benchmark federal funds rate, the interest rate that commercial banks charge each other for overnight lending, from 5.5 to 5.0 percent. To make this happen, it will pump more money into the economy, causing a decline in other short-term interest rates, such as the prime lending rate.
As a result, there will be a quick decline in many consumer interest rates so that automobile financing and home equity loan rates will be cheaper. Mortgage rates also could fall, although the Fed has no direct effect on long-term rates. The Fed also approved a half-point reduction, to 4.5 percent, in the discount rate it charges for direct bank lending.
Some analysts said the central bank would have to push interest rates down by at least another three-quarters to 1 point before the U.S. economy begins to turn around. “The Fed still is behind the curve,” said Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson, a Chicago investment banking firm.
However Brookings Institution economist Barry Bosworth called the Fed’s move “good, safe, middle-of-the-road action.”
The White House declined to comment on the rate cut, although President Bush continued to express his concern about the state of the economy and once again called on Congress to approve his tax cut bill.
Sen. Tom Harkin (D-Iowa), a persistent Fed critic on Capitol Hill, said he was disappointed that the central bank moved by only a half point.
“In the past, Alan Greenspan has talked about the `wealth effect’ of a rising stock market causing excessive spending and perhaps creating pressures that would accelerate inflation,” Harkin said. “Now, we have the opposite impact–the `poor effect.'”
Indeed, the “wealth effect,” essentially the rise in value of stock portfolios, has been cited by some analysts as one of the major factors in the economic boom of the last few years.
Even though the economy appeared to be close to stalling out in the last quarter of the year, in recent weeks it has shown some signs of life, with consumer spending holding up better than expected. At the same time, however, corporations have accumulated excess inventories as a result of the slowdown. Production has been curbed until these inventories are sold.
“This just doesn’t look like a recession,” said Bosworth. “This looks like a soft economy, but why run the risk? Inflation is just not a concern.”
Wesbury said that unless the Fed reduces short-term interest rates to close to 4 percent, “I think the recession will deepen and corporate problems will worsen. As a result, the stock market will fall further.”
He said he doubted the central bank’s action would cause the economy to pick up enough to reduce the excess in inventories. But Merrill Lynch’s Shipley said the inventory correction is well under way.
The Fed agreed, but added the U.S. economy appears to be stuck with excess capacity to produce goods that could persist “for some time.”
