News: Analysis & Commentary
The Kindest Cut of All
The Fed unleashes a surprise move to reverse a market-driven decline
No policymaker has studied the New Economy's contours more closely than Alan Greenspan. The Federal Reserve chairman was among the first to proselytize about the growth payoff of the technological revolution. So it's no surprise that Greenspan has swiftly swung into action now that a rocket-propelled tech boom has given way to a steep tech dive that risks dragging down the economy. On Jan. 3, smack in the middle of George W. Bush's carefully orchestrated economic summit in Austin, Greenspan stunned the President-elect and the markets with an atypically assertive move. Without waiting for a scheduled policy meeting, Greenspan's Fed slashed interest rates by 50 basis points and signaled that more cuts were in the offing.
Although a cut had been expected by the markets, the timing and size of the central bank's move caught everyone by surprise. But from now on, expect the unexpected from the Fed chief. Although he has principally been known over his 13-year Fed tenure as a cautious incrementalist who likes to telegraph his moves to the market, the New Economy monetary policy Greenspan is adopting to counter a New Economy slump is uncharacteristically bold. True, he's been known to roll the dice before, most recently in 1998 in response to the Asian economic meltdown. Now he needs to do so again, because Fed members are convinced consumer confidence has sunk to levels that are unjustified by economic fundamentals, a mind-set that could lead to a recession.
Even as Greenspan's bold move snatched the limelight away from Bush, it also gave him a big helping hand. Not only did it restore confidence to the faltering markets, it also underscored the concerns of the President-elect and his team about the slowing economy. Indeed, at a Jan. 3 press conference, Bush argued that the Fed's emergency action only underscores his central point: that America needs his proposed $1.6 trillion tax cut as recession insurance.
But if the President-elect clearly welcomed the move, he seemed genuinely taken aback by Greenspan's crashing of his Austin party. The Texan suggested the Fed's half-point easing "is not enough" to assure long-term growth, and insisted that he will move ahead with his controversial tax-cut plans. Business leaders who attended the summit were clearly more elated by the Fed action. General Electric CEO Jack Welch reported that the assembled execs "raised a glass of water to Mr. Greenspan" in an impromptu toast. Adds Boeing CEO Phillip Condit: The Fed cut was "a great move. Strong action was needed."
And Wall Street rejoiced as well. The Dow Jones industrial average rose nearly 3% on the news. The Nasdaq saw its biggest one-day gain ever, up 14%. And once again, shell-shocked traders began to talk about that long-delayed market rally.
The rate cut came just in time. The New Economy that generated America's longest economic expansion looked to be unraveling quickly. The hallmark of the era's prosperity has been a technology-driven, productivity-boosting investment boom that has been fed by a soaring stock market. But that has made it more susceptible to the risk of a sudden downturn. As growth slowed from the heady 8.4% pace of late 1999, corporate profits took a hit and a stock market priced for perfection slumped. The devastation in the market sapped consumer and corporate confidence. Companies, in turn, cut back on expansion plans and trimmed spending on new technology and workers. Consumers, faced with a sudden evaporation of stock wealth and news of layoffs, threatened to slam shut their pocketbooks. "We kept getting doses of bad news," says Michael C. Ruettgers, CEO of tech-storage giant EMC Corp. "Eventually, that creates a self-fulfilling prophecy."WAVE OF REFINANCINGS. Inside the Fed, alarm has been building for weeks over the swiftness of the economy's decline. It started in mid-December, when the University of Michigan's consumer confidence index plunged. Palms got sweatier as company after company missed earnings projections. The last bit of bad news was on Jan. 2, when the National Association of Purchasing Management reported that the NAPM December index was the worst since the spring of 1991.
In the short run, the Fed's shift to an aggressive monetary stance will benefit both consumers and the durable-goods sector. The wave of refinancings that was starting to sweep the housing sector will now turn into a flood. And easier credit terms could start to move some of that huge backlog of new cars on dealers' lots. Debt-strapped companies also will get a break, since the prime lending rate was cut in tandem. "A 50-point drop is kind of a slap in the face," says W. Van Bussmann, DaimlerChrysler's chief U.S. economist. "It's the Fed telling people, `Here's some more money to spend, you need it."'
Retailers, while welcoming the central bank's move, wish it had come a little sooner--in time to salvage disappointing holiday sales. "Maybe the reality of a slowdown has finally hit [Greenspan & Co.]," says Joseph Ettore, CEO of Ames Department Stores. "They had an opportunity to really make some hay before Christmas."
Elsewhere, even execs in hard-hit Techland opined that the shift to a full-throttle monetary policy could send a spark to their battered sector. "Money will be freed up for our customers to spend on technology," says George Samenuk, CEO of Network Associates Inc., a computer-security concern that warned investors in early January of a bleak fourth quarter that reflected a raft of order cancellations. "I'm going to be on the phone with customers to see if we can get some of these projects started again."
So much for the good news. The trouble is that there are long lags before monetary stimulus kicks in, and in the interim there are a lot more sickly earnings reports ahead from corporations. "Cutting interest rates now doesn't do anything for earnings in the short run," says Ian Shepherdson, chief U.S. economist at High Frequency Economics, in Valhalla, N.Y. "We're still in for a couple of quarters of dismal earnings."
True, the impact of monetary stimulus can take anywhere from six to 12 months to affect the real economy. But now that Greenspan is cutting rates in larger increments, he hopes to get a bigger psychological bang for his buck.
Moreover, however long the lags for monetary policy, the stimulative impact of the big tax cuts that President-elect Bush is seeking is even farther away. Bush argues that even a big-time dose of monetary liquidity won't be enough to put the economy on a solid long-term growth track. So he's continuing to raise concerns about recessionary "warning signs" in hopes of ginning up political support for his $1.6 trillion, 10-year package of tax-rate reductions and credits. If history is any guide, however, by the time the lawmakers get around to enacting any tax legislation, which usually doesn't happen before autumn, whatever underlying condition the plan was supposed to have cured has usually subsided. "As far as getting money into consumers' pockets quickly via tax cuts, it's pretty hard to do," concedes an economic adviser to Bush. "But with small business struggling, we still think lower marginal rates are needed. We've got to create a sense that this is urgent."
Yet much of Bush's tax plan has been designed to slowly phase in over nine to 10 years in order to minimize its budgetary impact. A smaller overall package, with perhaps an earlier effective date retroactive to Jan. 1, could solve some of the problem--but might look like a Bush retreat from his campaign vow to seek the biggest, boldest tax cut on the block. Hill Republicans say that Bush is still unlikely to get his plan to collapse the 39% and 36% tax brackets into a new 33% top rate. But he could eventually win some rate cuts for lower income-wage earners, plus eliminate the marriage penalty and inheritance taxes.
Business, not surprisingly, backs Bush's idea of a one-two punch of tax relief and Fed action. Says Jim Morgan, CEO of Applied Materials Inc.: "Counteracting forces like a rate cut and a good front-loaded tax cut could stop a steep slide." But most CEOs queried by BUSINESS WEEK reporters say that the size of the tax component needs to be scaled down and that the central bank should shoulder the primary burden of spurring growth.
Long before Bush's vaunted tax blueprint gets sliced and diced and massaged by Congress, the Fed will cut rates again to jump-start the economy. Some Fed watchers expect another 100 basis points by the middle of the year--the kind of monetary medicine that under most circumstances would restore robust growth.
The upshot: an early and aggressive Fed campaign could produce a visible payoff by midyear, while congressional committees are still gnawing at the bones of Bush's campaign tax plan. Right now, the President-elect might be a little peeved that Greenspan's surprise overshadowed his Austin extravaganza. In the long run, though, Bush may come to thank the Fed chairman for doing him--and the economy--a huge favor.By Rich Miller, Laura Cohn, and Lee Walczak in Washington, with Lori Hawkins in Austin, William Symonds in Boston, Stanley Holmes in Seattle, and Bureau ReportsReturn to top