Wall Street Journal

Fed Cuts Interest Rates a Half Point,
But Its Powers Seem to Be Limited

By GREG IP and GREG WHITE
Staff Reporters of THE WALL STREET JOURNAL

The Federal Reserve, delivering the lowest short-term rates since John F. Kennedy was president, is pursuing its most aggressive campaign in recent history to stimulate the economy. But it's a campaign whose goal seems more elusive with each passing day.

Tuesday, the Fed cut the target for its benchmark federal-funds interest rate to 2.5% from 3%, and left the door open to further rate cuts. "The terrorist attacks have significantly heightened uncertainty in an economy that was already weak," the Fed said in a statement explaining its action.

Including its emergency rate cut just before the nation's stock markets reopened on Sept. 17, the Fed has chopped U.S. rates a full percentage point since Sept. 11, and by a whopping four percentage points since the start of the year.

Even though Tuesday's Fed move was widely anticipated, the Dow Jones Industrial Average jumped 113.76 points to 8950.59.

But lower interest rates work only if they induce consumers and businesses to borrow -- and then spend -- more. And since the Fed began cutting rates, the growth in business borrowing has ground to a halt, and consumer-credit growth has slowed sharply. Only home mortgage lending is still growing at a healthy pace, and even that has taken a hit in the wake of the terrorist attack.

All this raises a troubling question: Are the headwinds facing the economy so great that no interest rate, even one approaching zero, can turn things around?

"The fear is that people are sufficiently spooked by the uncertainty sparked by the terrorist attacks, that they don't want to spend," says Gregory Mankiw, a Harvard University economist who specializes in monetary policy. "Lower rates are certainly a good thing -- the question is will they encourage enough spending to pull us out of what looks like a recession?"

For months, Mark Messer, an engineering technician in St. Augustine, Fla., has been scouting for property on which to build a new home to replace the two-bedroom apartment in which he, his wife and their daughter live. With mortgage rates inching lower, financing hasn't been an issue. But because Mr. Messer's employer is a subcontractor for aircraft maker Boeing Co. -- which has announced sharp cutbacks amid the slump in air travel -- Mr. Messer is worried about his job.

"I'm not even buying a new TV, in case I do lose my job," he says. "Interest rates could go down to 1%, and it still wouldn't make me apply for a loan," he adds.

Not an Issue

The chief executive officer of Milacron Inc., a maker of plastic molding equipment, plastic parts and metal tools, says much the same thing. His Cincinnati, Ohio, company is renegotiating its bank credit line and expects to pay a lower interest rate, thanks to the Fed. But that isn't going to prompt the company to borrow for expansion. "Because of the concern about the length of the downturn, we just do not want any additional debt," says CEO Ron Brown. The cost of borrowing, he says, isn't the issue.

Like many others in the hard-hit manufacturing sector, Milacron is a long way from needing to expand. "We have plenty of capacity, and it's going to take some time to get full use of that capacity," Mr. Brown says.

With demand down, the company, which had announced plans in July to shutter seven plants by the end of the second half, last week expanded the planned shutdowns to 12 small plants world-wide. It also said it now plans to lay off 800 employees, up from a previously planned 575, from its current work force of about 10,000. Mr. Brown says he won't even consider expansion until he sees a pick up in overall demand, and he doesn't anticipate a rebound in most sales until the first half of next year or in capital-equipment sales until the second half of 2002.

The effectiveness of monetary policy comes into question almost every time the economy turns down, most recently during the sluggish recovery from the nation's 1990-91 recession. Yet in each downturn since World War II, lower interest rates, sooner or later, have revived the economy. And, just Tuesday, there were heartening signs that the appeal of zero-interest-rate loans is luring hesitant consumers back into auto dealers' showrooms.

There are reasons to fear the Fed will have a harder time now. Last month's terrorist attacks on the World Trade Center and Pentagon were an event for which there is no historic or economic precedent. By comparison, the recession and credit crunch that coincided with the 1990 Iraqi invasion of Kuwait were a far milder shock to the U.S.

Nearly all the drags on the American economy before Sept. 11 -- mounting unemployment, falling stock prices, unused industrial capacity, a bandwidth glut, stubbornly high long-term interest rates, weakening economies abroad and, most of all, eroding confidence in the future -- were intensified by the terrorist attacks.

Eroding confidence is the factor that poses the biggest challenge to the standard remedies in the Fed's cupboard. National confidence turns not on interest rates but on things over which the central bank has no control: the public fear of another terrorist attack, the pictures on TV news, the ability of the president to calm the nation's anxiety, the capacity of the U.S. military to disable the terrorist network.

And then there is the unsettling example of Japan, the first major economy since the Great Depression to struggle with deflation and persistently weak demand that so far has been stubbornly resistant to both government spending and lower interest rates. Since the end of 1990, Japan's central bank has lowered its discount rate to the current 0.1% from 6%.

Most mainstream economists think lower interest rates and the tens of billions of dollars in the economic-stimulus program now in the works will turn the economy around. Many of them are predicting a rebound early in 2002. Monetary policy hasn't lost its potency, they insist. Push interest rates low enough, and people respond.

That's what auto makers are expecting. A week after the attacks, General Motors Corp., under pressure from its dealers and concerned that pessimism about the economic outlook would become a self-fulfilling prophecy, announced a zero-interest-rate financing offer covering its entire lineup of new cars and trucks. The promotion was backed up by a national ad campaign with the slogan, "Keep America Rolling."

"It's costing us more money, but we think it's a good tradeoff," says GM Chief Executive Rick Wagoner, who has been very vocal in the weeks since Sept. 11 about the need to stimulate demand in order to keep the terrorist attacks from pushing the economy into a deep downturn. He credits the Fed's rate cuts with helping make the offer possible. For GM, "zero-percent financing costs less in today's environment," he says.

The move, aided by President Bush's call to return to "business as usual," seems to be paying off. Within days, rivals matched GM's offer. Dealers say showroom traffic increased. Particularly outside the terror-shaken Northeast, sales are moving back toward pre-attack levels. "On Sept. 11, it was like somebody turned off a light switch, but it's been turned back on with the 0% financing," said Jesse Pridgen, a truck salesman at Capital Ford Inc. in Raleigh, N.C. Thanks to the appeal of no-interest loans, the dealership's September sales are about what they were last year.

Alan Rosen, chief executive of Continuum Chemical Corp., a Houston industrial-services company, bought two Ford pickups -- a $27,000 F-150 and a $29,000 F-350 -- for his business. "It was a deal you couldn't pass up because you're using Ford's money to finance your future," he says. He figures he saved between $7,000 and $9,000 in financing costs.

Big auto makers said Tuesday that sales in September held up much better than most in the industry and on Wall Street expected. GM's sales were only 2.9% below last September's levels. Ford says sales to consumers -- that is, excluding fleet and commercial sales -- were down just 2% or 3%, with the exception of the New York City area. And German auto maker Bayerische Motoren Werke AG's September sales in the U.S. set a record, although the 8.7% increase over last year was smaller than in any month this year.

Fed officials remain confident that monetary policy retains its power to get the economy growing. In congressional testimony in July, Fed Chairman Alan Greenspan said, "You essentially get very complex differences in the way monetary policy plays out, but at the end of the day, it does seem to be effective."

There is talk, both inside the Fed and among the analysts who track the Fed, about the risk of running out of ammo -- of dropping rates so quickly that they hit some floor, at or close to zero, with no room to cut further when the economy is still weakening. That could make the central bank look impotent and raise comparisons to Japan. But some Fed officials have the opposite worry: that the Fed will overdo rate cuts now so that inflation takes hold next year or the year after.

Such concerns, however, have been overtaken by an overriding desire to act quickly and get the impact of lower rates into the economy as quickly as possible. The federal-funds rate, at which banks lend to each other overnight, hasn't been at 2.5% since 1962. And the Fed cut the discount rate, the rate at which it lends to banks directly, by one-half percentage point Tuesday to 2%, at the request of eight of the Fed's 12 regional banks. That suggests a higher degree of consensus than has been the case recently.

Peter Hooper, chief U.S. economist at Deutsche Bank, thinks the Fed will move to quarter-point rate cuts now -- but not out of concern that rates will get to zero too quickly. "If they really think things are weak, they won't hold back," he says.

A number of factors are muting the economy's response to the Fed's rapid rate-cutting: Stock prices haven't risen much, as they usually do (despite a rally in the last week). The dollar isn't falling, as it usually does, so exporters aren't getting a boost, though it has weakened a bit recently.

And longer-term bond yields, which are the primary driver of mortgage rates, haven't fallen nearly as much as the short-term rates targeted by the Fed. In part that's because they fell a lot last year in anticipation of the Fed's action, a big reason the housing market didn't falter when so much of the economy did. And in part that's because Congress and the White House are working on a new fiscal stimulus package that could wipe out most if not all of next year's surplus, which means the government would be paying down little, if any, of its outstanding debt.

As a result, the rate on a 30-year fixed-rate mortgage rate has only fallen to 6.72%, compared with 7.38% at the end of last year, according to Freddie Mac, the big mortgage lender.

While applications to refinance mortgages are now above pre-attack levels, applications for mortgages from home buyers remain 9% lower, according to the Mortgage Bankers' Association of America.

Refinancing can be an important source of fuel for consumer spending. "I'm not worried about monetary policy having no impact," says David Hale, global chief economist at Zurich Group. "It's going to be in refinancing." He cites Fannie Mae data that suggests households have extracted some $70 billion to $80 billion in equity from their homes this year; if the Fed keeps short-term rates at current levels, figure could be $80 to $100 billion next year.

But mortgage refinancing may be losing some of its oomph, in part because of the failure of mortgage rates to match the drop in short-term rates. That has frustrated many potential borrowers. Dean McCaskill, vice president of Latin American sales for a security firm, has received numerous offers to refinance the $270,000 mortgage on his home near Fort Lauderdale, Fla., but when closing costs are included, he is unable to do much better than the 7.25% rate he got in 1998.

And more of those who are refinancing old, higher-interest mortgages aren't spending the proceeds. Sherri Steen, head of mortgage loan processing at Bar Harbor (Maine) Banking & Trust Co., hasn't had one application to purchase a new home in the past two weeks, though new loan applications are 20% above what the bank would normally expect. But most of the borrowers are using the money to pay off credit cards and other higher-interest loans. "People are being a little more cautious with the funds when they have it," Ms. Steen says.

The same is true out West. Gary Broaddus, president of Green Mountain Mortgage Corp. of Lakewood, Colo., says refinancing typically accounts for 20% of his business, and home purchases, about 80%. Today, that ratio has flipped, with some 80% of customers refinancing. Some of those are converting equity in their homes into cash that they park in money-market funds in case they get laid off. "People don't like to have uncertainty."

For others, plunging stock prices have overwhelmed the benefit of lower mortgage rates for some people. Israel Cuyler had been looking last year to trade up from the three-bedroom house he and his wife share in Rochester, N.Y. But the losses from his stock portfolio this year made it too difficult to finance both a new house and his two sons' college educations. In the wake of the terrorist attack, two potential clients put new contracts with his company, which performs janitorial services and lead and asbestos abatement, on hold. "Since the market tanked, I wouldn't buy a crippled crab," he says.

Such worries are why most economists expect the economy to contract in the current quarter and struggle back in the first or second quarter of next year. The times are unusual, they says, but the textbooks aren't wrong. With the usual lags -- which have never been easy to predict -- and some help from fiscal policy, monetary policy will pull the economy out of recession. "The question is how far do they need to go to offset the contraction in spending driven by the fear and uncertainty over the Sept. 11 attacks," says Harvard's Prof. Mankiw. "I have no doubt moving rates from 3%, to 2%, to 1%, or to zero will stimulate the economy."

Mr. Hale, the Zurich Group economist, rejects comparisons to the Great Depression of the 1930s or Japan in the 1990s. "Japan's banking system is rotten to the core," unable to do the basic lending needed for an economy to grow, he says. And in the 1930s, U.S. bank failures wiped out a third of bank deposits. "The banking sector was disintegrating." At first the present situation looks similar to 1991 to 1993, the last time the federal-funds interest rate fell below the inflation rate. But back then, banks were so weak and shellshocked, they wouldn't or couldn't meet the demand for credit. They are much stronger and able to lend now.

Judging by Tuesday's stock-market gains, some investors appear to think that lower interest rates will eventually prompt consumers, investors and businesses to conclude that the return from an investment will beat the cost of financing it. And just as it is difficult for economists and the Fed to predict the effects of the Sept. 11 attack, so, too, it is difficult to gauge the power of the patriotism it has produced.

Bill Franklin, a Texas police captain who knew President Bush as governor, was motivated to refinance his home in part by President Bush's televised speech to Congress. He used the savings from lowering his mortgage rate to 6.5% from 8.25% to finance a 1997 Ford pickup truck for his 17-year-old daughter. "I felt I could help the nation by helping the economy," he says.

-- Sholnn Freeman, Andrew Caffrey, Robert Gavin contributed to this article.

Write to Greg Ip at greg.ip@wsj.com³ and Greg White at greg.white@wsj.com⁴