By not cutting rates, the Fed is letting investors know it won't rescue them when markets sour. With the economy slowing fast, though, we all could suffer
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Vice-President Al Gore earned a fond place in history with a gracious concession speech lauded by even his most ardent ideological foes. But will Federal Reserve Board Chairman Alan Greenspan's "concession" statement on the economy garner similar reviews? Certainly not by the workers at General Motors, Gillette, and Aetna after management recently announced layoffs of 15,00, 2,700, and 2,400, respectively. And investors signaled their displeasure by knocking stock prices down sharply after the Federal Open Market Committee, the Fed's policymaking arm, failed to take decisive action against a slowing economy at its Dec. 19 meeting.
The Fed held the line on interest rates by keeping the fed funds rate at 6.5%. To be sure, Greenspan & Co. did concede that the economic downturn is now its primary concern by announcing a shift in monetary focus from inflation-watch to recession-watch. Yet the Fed's decision to stay the course is a huge gamble with the economy decelerating far faster than most forecasters anticipated even a few months ago (see BW Online, 12/20/00, "The Fed Has No Time to Dawdle"). What's more, with the leading inflation indicators tame and price competition picking up as the economy slows, why not ease -- if only a quarter of a percent cut in the fed funds rate?
Indeed, if the only question troubling the monetary watchdogs was the state of the economy and inflation, the central bank might well have acted differently. After all, the economic news is grim. Corporate capital-spending plans are shrinking fast, and pink slips are up sharply. Banks and other lenders are stingy with credit, and the stories emerging from corporate headquarters strongly suggest that management is hunkering down for tough times. Consumer confidence is down, and retail sales are surprisingly weak for the holiday season.
HAUNTED GOVERNORS. The economic tea leaves may be especially difficult to read during the first downturn of the New Economy era, but the more than 50% decline in the Nasdaq -- the stock market index for the New Economy -- is troubling. Looking at the economy in isolation, the evidence is compelling that the Fed should have taken out an insurance policy against a severe downturn next year by cutting rates now.
Then what stayed its hand? The central bank seems haunted by the brokerage-house refrain that Greenspan won't let the stock market decline too far or too fast. Yet economists -- including the Fed chairman, the nation's chief economist -- strongly believe that letting investors suffer financial loss is a valuable reminder that taking imprudent risks is costly. And stocks are risky -- it's in the nature of the investment.
From the Fed's perspective, the danger in easing now is giving credence to the Wall Street mantra that the stock market has become so central to the New Economy's performance that the Fed will limit any major losses. Economists call this classic central banker dilemma "moral hazard," a term typically associated with bank bailouts.
WEEKEND AT ALAN'S. Of course, the Fed doesn't want a falling stock market to severely undermine the real economy. Since central banking is much art as science, the Fed has decided that the risk of moral hazard is greater than the threat of a recession.
And Greenspan has the stature among investors to make the gamble seem reasonable. John McCain captured the awe Greenspan inspires during a GOP Presidential debate in Manchester, N.H., during the primary battle: "And by the way, I would not only reappoint Mr. Greenspan. If Mr. Greenspan should happen to die, God forbid, I would do like they did in the movie Weekend at Bernie's. I would prop him up and put a pair of dark glasses on him and keep him as long as we could."
The Fed's reminder to investors that financial foolishness doesn't pay is no bad thing. Let's just hope the price tag for the lesson isn't too steep.
Farrell is contributing economics editor for Business Week. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online Edited by Thane Peterson
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