June 21, 2003

Forthcoming Federal Reserve Rate Cut

The Washington Post's John Berry puts his ear to the ground and guesses that the Federal Reserve will cut interest rates next week by 0.50 percentage points (a 60% chance) or by 0.25 percentage points (a 40% chance). That seems about right to me--but his sources are much, much better than mine.

One bone to pick, however. John Berry says that economists were "surprise[d]" by the fact that "recovery has been halting and 'jobless' despite huge doses of monetary and fiscal stimulus." This economist hasn't been surprised. Simply look at the late-1990s boom and the structural sources of the acceleration in productivity growth, and a "jobless recovery" looked like a definite possibility.

Rate Cut Looking Like a Sure Thing (washingtonpost.com): ...Federal Reserve officials, concerned there is still no sign of the solid pickup in U.S. economic growth needed to foreclose the possibility of deflation, appear certain to cut their target for overnight interest rates next week.

There is broad agreement among investors and analysts that a rate cut is coming, but there is disagreement about whether policymakers will lower their 1.25 percent target by a quarter-percentage point or by a half-point. The latter seems to be more likely as a sort of exclamation point to emphasize that the officials believe this will be the final step that, coupled with the income tax cut that will show up in workers' take-home pay next month, will put the economy on a strong, sustainable growth path.

Fed Chairman Alan Greenspan, who gave the first hint that he was contemplating another rate cut in testimony before a congressional committee on May 21, referred then to such a step as "taking out insurance."

"We believe that because in the current environment the cost of taking out insurance against deflation is so low, that we can aggressively attack some of the underlying forces, which are essentially weak demand," Greenspan told the committee.

Several other Fed officials have expressed similar views in recent weeks. By "cost" Greenspan meant the risk that another rate cut could so stimulate economic activity that it would cause inflation to become significantly worse. But in this instance, such an outcome would almost be welcome.

A rate cut by the central bank next week would be the 13th since January 2001 on the eve of a recession when the rate target was 6.5 percent. The Greenspan-led Fed cut rates aggressively as the economy contracted through that year, and growth resumed in 2002. But to the surprise of economists and policymakers, the recovery has been halting and "jobless" despite huge doses of monetary and fiscal stimulus...

Posted by DeLong at June 21, 2003 06:48 AM | TrackBack


Stephen Roach has written an interesting column arguing that the Federal Reserve allowed the stock market bubble to develop, then in trying to handle to damaging effects of the bursting of that bubble fostered bubbles in housing and bonds.

The problem for householders that develops from bubbles, is relying on asset appreciation to add to wealth and for consumption. So, savings fell during the stock market bubble. After the stock market fall, householders have relied on appreciation of home and bond prices to continue consuming.

Posted by: anne on June 21, 2003 09:12 AM

Referring to bubbles, Paul Krugman is arguing that we have another bubble in the stock market. The S&P price/earning ratio was 30 at the end of May, and considerably higher if pension fund short falls and options costs are included. Richard Bernstein at Merrill Lynch is suggesting the same. Buying stocks at such valuation levels and expecting returns of 10% going forward, does not seem reasonable.

Posted by: anne on June 21, 2003 09:30 AM


Merrill Lynch is telling investors that the Fed has been making a mistake with such an agressive lowering of interest rates. The rate cuts have allowed too many companies to continue operating, so capacity utilization has not begun to rise yet. Also, Merrill is pointing out that individual investors are again leading the stock purchasing.

Posted by: jd on June 21, 2003 10:01 AM

Well, the NASDAQ 100 has a p/e ratio above 200 and the only sense I have of investors is regret that they can only afford so many shares in EBay. Of course, interest rates are low and the economy and earnings should soon be booming. Why not EBay? The problem is stocks are generally expensive, some more so, and bonds are expensive.

Posted by: bill on June 21, 2003 10:13 AM

Nothing wrong with profit taking! I know market timing is probably simple fortune telling, but selling "expensive" holdings for less expensive does make sense now and then.

Posted by: arthur on June 21, 2003 10:35 AM

arthur, just for the record, it isn't "market timing" to decide a given stock is overvalued. That's just intelligent market decision-making.

To return to brad's primary point, the prospects for job creation remain awful. It's simply not possible (and here i'm merely repeating something brad and others have pointed out before) for productivity growth to be more than 1% higher than GDP growth and robust job creation to occur.

meanwhile, when we finally start to get some further GDP growth (i'm betting that we're back up to somewhere between 2.5% and 3.0% in the next 6 months), we're going to see interest rates jump, mortgage rates jump, housing prices fall, and people who have lots of floating-rate interest stretched verrrrry thin.

Followed, in my estimation, by a period of stagflation that should really become evident by, oh, november, 2004.

Posted by: howard on June 21, 2003 11:02 AM

Howard, I agree. Stocks returns have been superb, stocks are expensive, so I have been profit taking the past few days.

Posted by: arthur on June 21, 2003 12:26 PM

GDP growth of 3% will not be enough to make a dent in the job losses that have been experienced these past 2 years. Productivity growth is high enough that we will need GDP growth above 3.5%, possibly above 4%, to cut the jobless total.

Posted by: dahl on June 21, 2003 12:26 PM

Unless job creation climbs above 80,000 a month, I do not think interest rates will rise much this year.

Posted by: dahl on June 21, 2003 02:20 PM


Does Merrill think that when a company goes out of business its factories disappear?

Posted by: Bernard Yomtov on June 21, 2003 02:51 PM

Merrill is thinking that capacity will be set idle as a business fails or is bought up. I agree, but am not really decided about whether the Fed "should" lower rates. I always respect the ideas of Richard Bernstein, though I may not agree.

Posted by: jd on June 22, 2003 07:51 AM

I disagree that the cost to lowering the interest rate is little. Yes, it is small in respect to continued low inflation. However, it is leading to inflation in one important area, housing. We are in the midst of a housing bubble it is clear. Developers are overbuilding rental units and family homes at a large rate to take advantage of the low interests. People are building and buying larger homes than they could afford at higher rates.

So what happens when the economy recovers and rates go up again? Starts on rental units will collapse. People will be stuck with large dwellings that are no longer affordable. The Fed is replacing the stock bubble with the housing bubble. Meanwhile, retirees living on fixed income do not have a lot of investment returns from CDs that they can spend. Lowering the interest rates adversely affects this part of the economy. The middle class elderly have less income to spend.

With the end of fixed output pensions and the reliance on 401 fixed input accounts, the baby boomers are not going to be retiring at 67. That will be unaffordable.

The current economy cannot be fixed with monetary policy alone. It needs a sound fiscal policy. Unfortunately, the ideology of the current administration is exactly wrong for the present economic period.

As for monetary policy, interest rates should not be cut. The Fed should never let the rates go much below 3% and cried uncle way back when. That might have forced the administration to attack the economy with sound fiscal policy. To cut interest rates is wrongheaded. There are benefits to letting them drift upward and dampen the housing bubble.

Posted by: bakho on June 23, 2003 09:02 AM
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