Will the Fed Cut Interest Rates?

Greg Ip of the Wall Street Journal writes a "Fed will cut interest rates" story. It's no secret that I think that the Fed should, both because demand growth is slack and because (due to rapid productivity growth) potential supply growth is strong. The Fed's job is to keep the output gap between effective aggregate demand and potential output supply as small as possible. But it is not clear to me that the arguments within the Fed today that I favor are as strong as Greg Ip thinks they are...

---

WSJ.com - Lethargic Economy Could Tip Fed Toward Interest-Rate Cut: ...It isn't clear that those favoring pre-emptive action over patience will be in the majority when the Fed's policy committee meets next week in Washington. But if business executives remain gloomy and economic data downbeat, those favoring action likely will prevail in December. At that point, the debate will be about the size of the cut, with officials most in favor of pre-emptive action also pushing for a half -- rather than quarter percentage-point reduction. More than usual, the decision will come down to Fed Chairman Alan Greenspan. He has been optimistic on the economy since the summer, arguing that current restraints to growth are temporary. But lackluster economic data and even gloomier business leaders are testing that optimism. Mr. Greenspan strongly believes psychology can play a big role in what the economy does, though economic models might predict otherwise. His history also is one of favoring pre-emptive action, such as during the debt-markets crisis of 1998 and after the terrorist attacks last fall, even when the underlying problem isn't economic.

The Fed's short-term interest rate has stood at 1.75% since December. But at their August meeting, Fed officials said risks now were weighted toward economic weakness, rather than being balanced between weakness and inflation. Still, few officials thought a rate reduction would follow, because the shocks appeared to be temporary, economic data unusually volatile, and monetary and fiscal policy stimulative enough to pull growth back to an annual rate of 3% or better by year end. At its September meeting, the Fed again kept rates unchanged and risks tilted toward weakness, but more officials seemed inclined to lower rates if the data didn't improve in the months ahead. Two policy makers dissented from that decision, arguing in favor of reducing rates immediately. Since August, what looked like a temporary soft spot hasn't looked so temporary. Economic numbers suggest a slow-growing economy, though not one falling back into recession. Economists estimate third-quarter growth was 3.7% at an annual rate, according to a survey by Macroeconomic Advisers LLC, but that was buoyed by car sales featuring financing deals with zero-percent interest. Such sales have since fallen back. Economists expect growth of just 1.8% in the fourth quarter, according to the survey...

Lethargic Economy Could Tip
Fed Toward Interest-Rate Cut

By GREG IP
Staff Reporter of THE WALL STREET JOURNAL

WASHINGTON -- With the U.S. economy showing no signs of recovering upward momentum, the Federal Reserve appears likely to cut interest rates in coming months from what already are the lowest levels in more than 40 years.

But before such a reduction can be made, Fed officials who favor moving pre-emptively against further economic weakness must win over colleagues who advocate waiting for political and financial uncertainty to wane, as well as for the Fed's previous rate cuts to take effect. It isn't clear that those favoring pre-emptive action over patience will be in the majority when the Fed's policy committee meets next week in Washington. But if business executives remain gloomy and economic data downbeat, those favoring action likely will prevail in December. At that point, the debate will be about the size of the cut, with officials most in favor of pre-emptive action also pushing for a half -- rather than quarter percentage-point reduction.

More than usual, the decision will come down to Fed Chairman Alan Greenspan. He has been optimistic on the economy since the summer, arguing that current restraints to growth are temporary. But lackluster economic data and even gloomier business leaders are testing that optimism. Mr. Greenspan strongly believes psychology can play a big role in what the economy does, though economic models might predict otherwise. His history also is one of favoring pre-emptive action, such as during the debt-markets crisis of 1998 and after the terrorist attacks last fall, even when the underlying problem isn't economic.

The Fed's short-term interest rate has stood at 1.75% since December. But at their August meeting, Fed officials said risks now were weighted toward economic weakness, rather than being balanced between weakness and inflation. Still, few officials thought a rate reduction would follow, because the shocks appeared to be temporary, economic data unusually volatile, and monetary and fiscal policy stimulative enough to pull growth back to an annual rate of 3% or better by year end.

At its September meeting, the Fed again kept rates unchanged and risks tilted toward weakness, but more officials seemed inclined to lower rates if the data didn't improve in the months ahead. Two policy makers dissented from that decision, arguing in favor of reducing rates immediately.

Slow-Growing Economy

Since August, what looked like a temporary soft spot hasn't looked so temporary. Economic numbers suggest a slow-growing economy, though not one falling back into recession. Economists estimate third-quarter growth was 3.7% at an annual rate, according to a survey by Macroeconomic Advisers LLC, but that was buoyed by car sales featuring financing deals with zero-percent interest. Such sales have since fallen back. Economists expect growth of just 1.8% in the fourth quarter, according to the survey.

"The economy continues to grow, but clearly at a pace that is slower than one would like," Federal Reserve Bank of Philadelphia President Anthony Santomero, considered a centrist among the 12 voting members of the Fed's policy committee, said earlier this month. "If we use our monetary-policy tools appropriately, we'll be able to sustain a recovery and lead to an expansion."

Fed officials broadly agree that interest rates already should be low enough to generate a healthy recovery, and that the obstacle is pervasive uncertainty holding back business investment. But they differ on what to do about it.

'Patient' School

The "patient" school argues the main source of weakness now -- uncertainty related to corporate governance and tensions with Iraq -- can't be addressed by monetary policy.

For example, they assert it would be unwise to ease monetary policy because of the Iraq standoff since, for all the Fed knows, it could end in a quick resolution, a plunge in oil prices, a surge in growth and a need for higher, not lower, rates.

This group says the Fed has plenty of time to lower rates later if one of these uncertainties concretely threatens the economy. If it tried to fine-tune now with no effect and a real shock did come later, they maintain, the Fed would have less rate-cutting ammunition with which to react.

'Pre-emptive' School

The other, "pre-emptive" school argues that as uncertainty drags on, that alone will seriously depress growth. The Fed, they state, can offset that by providing support to areas of the economy, in particular consumer spending, that still respond to interest rates. And if rate reductions prove unnecessary, they can be rapidly reversed.

This group also affirms that the Bank of Japan erred by cutting rates too slowly to keep that economy from slipping into deflation and stagnation, so that the lesson for the Fed is to fire its ammunition early, not to conserve it.

In the past month, the patience of some previously patient officials has appeared to be running thin. The stock market's rebound hasn't weakened the case for easing and may have strengthened it. The rebound hasn't been accompanied by lower relative corporate-bond yields, and the profit outlook for the fourth quarter actually has worsened. By cutting rates soon, the Fed could avoid the impression that the stock market drives its decisions.

Write to Greg Ip at greg.ip@wsj.com¹

Posted by DeLong at October 28, 2002 01:30 PM | Trackback