Can Rate Cuts Do the Job?


It may be hard to remember, but Alan Greenspan hasn't always enjoyed his current celebrity status as the infallible oracle of the economy. In fact, he has been dead wrong in the past. Back in 1990, for instance, Greenspan's record as Federal Reserve chairman was stained when, putting his faith in none-too-accurate data, he failed to cut interest rates fast enough to head off a recession. The slump hit with a vengeance when an oil-price surge, sparked by Iraq's invasion of Kuwait, ruined consumer confidence. Still, Greenspan held back from aggressive rate-cutting because the data still showed a growing economy. It was only later, after the numbers were repeatedly revised, that it became clear the slump had started months before the Fed chief had realized.

This time around, Greenspan isn't waiting for the revised numbers. In a surprisingly blunt admission, he told lawmakers on Jan. 25 that economic growth is "probably very close to zero," even though official statistics indicate otherwise. And he immediately went to work to turn the economy around. On Jan. 31, the Fed eased credit for the second time in less than a month, chopping the key overnight interbank-lending rate by another half-percentage point, to 5 1/2%. The back-to-back reductions were the most dramatic cut in borrowing costs in nine years. And Greenspan and the Fed promised more cuts to come, perhaps even before their next scheduled meeting on Mar. 20.

Clearly, Greenspan has in large part acted so swiftly because the economy has been hit by what is turning out to be a very unfamiliar and abrupt slowdown. It's a New Economy slowdown, in which the bad news has been coming thick and fast: plunging consumer confidence, sharply declining growth, and a recession throughout much of the manufacturing sector.

QUICK ON THE TRIGGER. The big question is whether the slowdown will be followed by a New Economy upturn that arrives just as swiftly and unexpectedly. No one knows for sure. But like Greenspan, business leaders are reacting with lightning speed. Armed with up-to-the minute information on business conditions, companies have been quick to trim capital spending, inventories, and payrolls in a bid to keep profits up. And the layoff notices are piling up in what seems to be a much earlier point in a downturn than ever before.

The suddenness of the slowdown has surprised everyone, Fed officials included. And it has raised questions about whether the central bank's campaign of aggressive rate-cutting will be enough to forestall a recession. What's most distressing, some Fed insiders say, is that there is no clear sign yet of the economy bottoming out. The next few months will be crucial.

By Greenspan's reckoning, the key is psychological: bolstering a delicate interplay between corporate and consumer confidence. Expect Greenspan and the Fed to pull out the stops over the next few months with more rate cuts to achieve that goal. And expect the Bush Administration and Congress to try to do their part with talk of bigger and quicker-acting tax cuts.

L-SHAPED CURVE. If public faith in the economic future cracks, then the U.S. is headed for a nasty recession followed by an extended period of little or no growth. Picture an L-shaped curve -- "L" as in "lingering" -- and the dreary picture is plain to see. Not altogether different from the situation in Japan, though far less severe, such a scenario would feature a long period of sluggish growth that feeds on itself and keeps piling up the gloom.

At the moment, there's no lack of bad news. Corporate outlays on equipment and software, which as recently as a year ago were growing at a 21% annual clip, slumped nearly 5% in the fourth quarter of last year. And in the latest wave of layoff news, DaimlerChrysler announced on Jan. 29 that it will cut its Chrysler unit's workforce by 20%, or 26,000 workers, over the next three years. Just one day later, Amazon.com Inc. said it would close down facilities and eliminate up to 1,300 jobs, or 15% of its workforce.

But a recession is hardly a foregone conclusion. The Fed is hoping that corporate cutbacks will prove short-lived and that inventories and payrolls will be brought speedily into line. And, after a brief shakeout, capital spending will revive rapidly to take advantage of the New Economy efficiencies that Greenspan fervently believes are still there to be tapped.

STEEP IN, STEEP OUT? At best, that could lead to what Greenspan has called a classic "V"-shaped rebound: steep in, steep out. At worst, the recovery would be "U"-shaped, with growth picking up, albeit gradually, after the current pause. But that corporate turnaround won't occur if consumer confidence cracks. If nervous shoppers sharply curtail spending, that could trigger another round of business bloodletting. And the economy could be headed for that elongated "L."

That's why the news on Jan. 30 that consumer confidence during that month suffered its biggest drop in more than a decade was so worrying. Consumer optimism began to weaken last fall as the sagging stock market soured the spirits of wealthy Americans. But now the pessimism has begun to spread as the steady flow of corporate-layoff announcements has taken its toll on rich and poor alike. "It concerns me when a company like Chrysler has to lay off a lot of people," says Teresa M. Carino, a 38-year-old self-employed computer consultant in Lake Orion, Mich. "People in this area are going to be out of work and looking to start home-based businesses, which is going to hurt me."

The surge in energy prices is also crimping consumer and corporate confidence. "Our natural-gas costs have nearly doubled both at home and at our stores," says Nancy A. Dehoff, vice-president of the Dehoff Enterprises supermarket company in San Mateo, Calif. All told, reckons Jerry J. Jasinowski, president of the National Association of Manufacturers, rising oil and gas prices have cost the U.S. economy $115 billion over the past two years.

Fortunately for the Fed, most consumer pessimism is centered on the future. Ask consumers how they're doing right now and they tend to answer: "Not all that bad." That means the central bank mandarins still have a shot at heading off a gut-wrenching downturn.

PLASTIC PATCH. The stock market rally triggered by the Fed's aggressive rate campaign should help. Since the central bank surprised the market with its first half-point rate reduction on Jan. 3, the Nasdaq has soared 21% while the broader-based Standard & Poor's 500-stock index has risen 6.5%.

The Fed's repeated interest-rate cuts should put more money into cash-strapped consumers' pockets by lowering the cost of servicing credit-card and other debt. The lower rates have also touched off a refinancing boom by homeowners. Neal Soss, chief economist at Credit Suisse First Boston, calculates that the refinancing wave will save homeowners some $12 billion in interest payments this year. Those savings will climb higher if rates keep falling.

A further boost to consumers' pocketbooks could come in the form of a midyear tax cut, perhaps as much as $50 billion. To allow workers to take home more of their paychecks, the Treasury is likely to adjust the government's tax withholding. While that won't help forestall a downturn in the next few months, it could ensure that any decline that does occur ends quickly.

What it all comes down to is a massive roll of the dice by Dr. Greenspan. He's betting the New Economy isn't merely a house of cards built on fleeting stock market wealth and bulging consumer debt. Greenspan remains convinced that the longer-term outlook for productivity, profits, and pay is bright. Now all he has to do is get consumers and companies to keep the faith. If he can do that, he stands a good chance of steering the economy clear of the worst and avoiding another blot on his record. By Rich Miller in Washington, D.C., with Ann Therese Palmer in Chicago


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