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Fed Easing Cycle To Slow?

The Federal Reserve begins a two-day meeting today to set short-term interest rates, and traders are divided on whether the Fed will cut rates by 25 or 50 basis points when it adjourns tomorrow at 2:15 p.m.

Fed officials have clearly begun to worry about the economy and its lack of response to aggressive rate cuts. At the same time, there is a growing chorus of Fed officials worried that the aggressive action could ignite inflation. As a result, the outcome of the meeting is very much in doubt.

John Berry of the Washington Post wrote a front-page story last week that began with this: "As U.S. economic growth remains stubbornly sluggish, some Federal Reserve officials are growing increasingly concerned that unusual developments may be clogging the main channels through which lower interest rates normally stimulate the economy."

Berry's sources at the Fed are second to none, so the odds are high that he's reflecting the views of at least a few key Fed officials. And what those officials are thinking, according to Berry, is that a rebound might not occur until 2002, and even then it might start out weaker than expected. As we pointed out three weeks ago, the defection of Fed Governor Laurence Meyer from the hawk camp marked a significant shift in the Fed's view of the economy.

But Berry also wrote that it is unclear whether the Fed will cut rates by 25 or 50 basis points tomorrow. Any rate reduction now won't hit the economy until the end of the year, and some Fed officials think the economy may be recovering by then and that inflation will be the main concern.

We're not sure if inflation should be the biggest worry here; deflation probably merits equal concern. Periods of disinflation and high levels of investment in new technologies have historically tended to end in deflation.

But one thing shouldn't be in doubt at this point: the Fed has a full-blown crisis on its hands. Inventories remain high, and high consumer and corporate debt are making headway difficult. Commodity prices remain in free fall, the strong U.S. dollar is hampering export markets, and long-term interest rates haven't come down much at all. About the only thing holding up is consumer confidence, and it's just a matter of time until the steady stream of negative economic news takes its toll there. The steepest decline - by far - in household wealth in the 55 years that the data has been tracked has to be felt at some point.

But the most troubling thing of all is the failure of the stock market and the economy to respond to Fed rate cuts, which should be starting to be felt by now. As we have pointed out before, there are only two historical precedents for this: 1929-1932, and 1981-1982 - which was the worst recession since the 1930s.

A look at Federal Reserve historical data on the discount rate (ftp://ftp.ny.frb.org/discount/Discount) is revealing. In 1981, the Fed cut the discount rate from 14 to 12 between October and December, a 14% reduction in the rate. However, the Fed did not cut the rate again until July 1982, when it began a series of aggressive rate cuts. The stock market bottomed a month later.

Beginning in November 1929, the Fed cut the discount rate almost to the day as aggressively as it is cutting now: from 6 to 3.50 in 4 1/2 months, a 41% reduction in the rate. The two periods - 1929-1930 and 2001 - stand alone as the most aggressive in the Fed's 88-year history. By May 1931, the rate stood at 1.50.

That's not to say that the U.S. economy will face anything like the troubles it did in the 1930s. But at a minimum, there are excesses in the economy that will take time to work off, and Fed rate cuts will do little to speed that process. The Fed's view of a weak recovery beginning next year is probably a reasonable one, and it also mirrors what some analysts have predicted for the semiconductor and telecom equipment sectors.

If the Fed cuts by only 25 basis points tomorrow, there could be a silver lining. Fed officials have long wrestled with a central dilemma: whether businesses put off new investments during Fed rate-cutting cycles in the hope that rates will get even lower. If the Fed signals an end to the easing cycle tomorrow - or at least an end to the most aggressive part of the cycle - businesses could be forced to implement delayed spending plans.

That might not be a bad gamble on the Fed's part. Nothing else has worked so far.



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